A PROJECT REPORT

ON

"CREDIT RISK MANAGEMENT SYSTEM IN BANK"

By
ATUL KUMAR CHAUDHARI
(Registration No. 521124527)

A project report submitted in partial fulfillment of the requirements

for the degree of Master of Business Administration of
Sikkim Manipal University, INDIA

INSOFT, C – 2 SECTOR – 10, NOIDA – 201 301

CENTRE CODE – 1822

SIKKIM – MANIPAL UNIVERSITY OF HEALTH, MEDICAL AND TECHNOLOGICAL

SCIENCE DISTANCE EDUCATION WING, SYNDICATE HOUSE, MANIPAL – 576104

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 DECLARATION

I hereby declare that the project report entitled:

A Project Report on “Credit Risk Management System in Bank” submitted in partial

fulfillment of the requirement for the degree of Masters of Business Administration to
Sikkim – Manipal University, India, is my original work and not submitted for the award
of any other degree, diploma, fellowship, or any other similar title or prizes.

Place: Noida

Date: _________
Atul Kumar Chaudhari
(Registration No. 521124527)

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 CERTIFICATE

The project report of Mr. Atul Kumar Chaudhari (Registration No. 521124527)
A Project Report on “Credit Risk Management System in Bank” is approved and is
acceptable in quality and form.

Internal Examiner External Examiners

(Mr. _________)

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 ACKNOWLEDGEMENT

I am thankful to all the faculty members of Insoft, Sector-10, Noida for their valuable guidance
and support at all time and providing me the proper guidance to carry out research effectively
and efficiently.

I am thankful to all those people who provided me all the necessary information directly or
indirectly throughout my project report completed at time.

Atul Kumar Chaudhari

(Registration No. 521124527)

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 TABLE OF CONTENTS
Page No.

● Executive Summary 06

● Introduction 08

● Problem of the Study 85

● Objective 87

● Research Methodology 88

● Analysis 90

● Conclusions 97

● Recommendations 98

Bibliography 99

Appendix 100

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 EXECUTIVE SUMMARY

Credit risk is the oldest and vital risk banks are exposed to and significance of its management is
increasing with time due to reasons like economic stagnation, company bankruptcies, violation
of rules in company accounting and audit, borrowing becoming easy for small firms, financial
globalization and BIS risk based capital requirements.

Credit risk can be defined as the risk of losses caused by default of borrowers. Default occurs
when borrower cannot meet his financial obligations. Credit risk can also be defined as a risk
that a borrower deteriorates from credit quality.

Credit risk management can be viewed at two levels – at the level of an individual asset or
exposure and at the portfolio level. In credit risk management, banks use various methods such
as credit limits, taking collateral, diversification, loan selling, syndicated loans, credit insurance,
securitization, and credit derivatives, etc. While financial institutions have faced difficulties over
the years for a multitude of reasons, the major cause of serious banking problems continues to be
directly related to lax credit standards for borrowers and counterparties, poor portfolio risk
management, or a lack of attention to changes in economic or other circumstances that can lead
to a deterioration in the credit standing of a bank's counterparties.

The goal of credit risk management is to maximize a bank's risk-adjusted rate of return by
maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit
risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Banks
should also consider the relationships between credit risk and other risks. The effective
management of credit risk is a critical component of a comprehensive approach to risk
management and essential to the long-term success of any banking organization.

For most banks, loans are the largest and most obvious source of credit risk; however, other
sources of credit risk exist throughout the activities of a bank, including in the banking book and
in the trading book, and both on and off the balance sheet.

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Since exposure to credit risk continues to be the leading source of problems in banks world-wide,
banks and their supervisors should be able to draw useful lessons from past experiences. Banks
should now have a keen awareness of the need to identify, measure, monitor and control credit
risk as well as to determine that they hold adequate capital against these risks and that they are
adequately compensated for risks incurred. The Basel Committee has issued a paper on
principles of credit risk management so as to encourage banking supervisors globally to promote
sound practices for managing credit risk.

Although specific credit risk management practices may differ among banks depending upon the
nature and complexity of their credit activities, a comprehensive risk program should address the
following four areas:-

(I) Establishing an appropriate credit risk environment; (ii) operating under a sound credit-
granting process; (iii) maintaining an appropriate credit administration, measurement and
monitoring process; and (iv) ensuring adequate controls over credit risk.
While exact approach chosen by individual supervisors will depend on a host of factors,
including their on-site and off-site supervisory techniques and the degree to which external
auditors are also used in the supervisory function, the principles set out by Basel Committee
should be used in evaluating a bank’s credit risk management system. Supervisory expectations
for the credit risk management approach used by individual banks should be commensurate with
the scope and sophistication of bank’s activities.

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 INTRODUCTION

CREDIT RISK MANAGEMENT

1. Structural increase in bankruptcies

After the recession hit in different countries, most statistics show increase in
bankruptcies. Since there has been a permanent or structural increase in bankruptcies due
to increase in global competition, credit risk analysis has become even more important.

2. Disintermediation
Expansion of capital markets and access to small and mid-sized firms have lead to
increase in number of borrowers “left behind” to raise funds from banks who have
weaker credit ratings. Capital market growth has produced a “winner’s curse” effect on
the credit portfolios of traditional FIs.

3. More Competitive Margins

Interest margins or spreads in wholesale loan markets have become very thin. In other
words, risk-return trade-off from lending has become worse. One of the reasons is
enhanced competition for lower quality borrowers, especially from finance companies.

4. Declining and Volatile Values of Collateral

Banking crises in well-developed countries and concurrent debt crises in Asia and Russia
have shown that property and real estate values are very hard to predict and to realize
through liquidation. There has been decline in the values of collateral thereby making
them weak.

5. The Growth of Off-Balance Sheet Derivatives

The growth of credit exposure or counterparty risk has extended the need for credit
analysis. In many US banks off-balance sheet exposure to intruments such as OTC swaps
and forwards is more than 10 times hence raising the size of off-balance sheet exposure.

6. Technology
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 Advancements in information technology or computer systems have given banks and FIs
the opportunity to test high powered modeling techniques.

7. The BIS Risk-Based Capital Requirements

The main reason for banks to develop new credit risk models has been dissatisfaction
with the BIS and central banks’ post-1992 imposition of capital requirements on loans, so
called BIS I.

Basel Committee defined Risk as “the probability of unexpected happening", the probability of
suffering a Loss.

R = Rare (unexpected)

I = Incident (outcome)

S = Selection (Identification)

K = Knocking (measuring, mentoring & controlling)

TYPES OF RISK:

The risk profile of an organization may be reviewed from following angles

A BUSINESS RISKS

a. Capital Risk
b. Credit Risk
c. Market Risk
d. Liquidity Risk
e. Business Strategy & Environment Risk
f. Operational Risk
g. Group Risk
B CONTROL RISKS

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 a. Internal Control
b. Organisation
c. Management (including Corporate Governance)

Both these risks , however are linked to three omnibus risk categories are:

1. Credit Risk

2. Market Risk

3. Operational Risk

Risk Management is the strategic tool, which helps in identifying, quantifying, monitoring and
controlling risks. Risk Management protects an organization from insolvency resulting from the
adverse effects of risks. Though universally relevant it is of immense importance to a banking
organization or financial institution because of high leverage. In view of the same Risk
Management is analyzed here from the banking perspective. However with the larger corporate
houses establishing their own independent dealing rooms, risk management system are no longer
limited to banking organization due to cash surplus at certain times.

A banking organization has to constantly strike a risk & reward balance. A proposal, which may
seem very rewarding in the short term, may wipe out the bank completely in the long run due to
high risk embedded in it. Risk Management helps the banks in striking this balance. Thus Risk
Management systems are not a solution, but a tool to aid decision-making.

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BASIC ELEMENTS

Enterprise wide Risk Management is an ongoing business process. The segmented approach
implemented by the industry to address each risk separately is no longer considered efficient,
while EWRM has been identified as the ultimate mantra for survival and success, because:

 It will allow an organization to assess the impact of risks across the enterprise and
thereby make quick management decisions.
 It will help to meet the regulations laid down by the second Basel Accord regarding
refinement of existing approaches to credit risk and the new arena of operational risk.
 It will increase credibility and accountability, allowing greater transparency in
operation to regulate the flow of returns.
 It will save time and effort and the management will be able to take instant decisions
as risk exposure will be detected on time.
 It will help the organization to collect sufficient historical data to qualify for lower
capital charges obligations put forward by the 2nd Basel Accord.
 It will ensure the Basel II deadline of implementing the appropriate risk management
practices and the collection of five years of historical data.
 It will improve corporate image to sustain fierce competition in the global financial
market.

Risk normally has two dimensions i.e. Quality of Risk and the Quantity of Risk. Quality of risk
is essentially the probability of the risk turning into an actual loss. Quantity of risk is the
financial effect of the risk turning into a loss. Both these dimension are extremely difficult to
measure, primarily because it is an estimation of the future, which is highly uncertain. To
understand Risk Management it is extremely important to understand the various types of risks,
their characteristics and their inter-relationships.

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To study broad contours of management of credit, market and operational risk. Also covering
Asset-Liability Management which are purported to serve as a benchmark to various banking
systems.

Though the risk management area is very wide and elaborated, still the project covers it in
entirety albeit concise manner. The organized can use the study to find out the gaps in
implementation and also in planning the work to be undertaken in the future.

The study aims at learning the techniques involved to manage the various types of risks, also
involved are the various methodologies undertaken. The application of the techniques involves
us to gain an insight into the following aspects:

 An overview of the risks in general.

 An insight of the risks attached to the banking sector and specifically to the credit
portfolio of the PNB.
 The methodology related to the working of Risk Management Department
(RMD), Credit Administration Department (CAD) Treasury (MID OFFICE) and
Operational Risk Department at PNB.
 Calculation and interpretation of various models to mitigate the risks such as Z-
score Model, Gap Analysis and Credit Risk Rating Model etc.
 Tools applied in for measurement and management of various types of risks.
 Having an insight into the practical aspects of the working of various
departments.
The report seeks to present a comprehensive picture of the various risks inherent in the bank. The
risks can be broadly classified into three categories:

o Credit risk
o Market risk
o Operational risk

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 BASEL II – A REVISED FRAMEWORK

“INTERNATIONAL CONVERGENCE OF CAPITAL

MEASUREMENT AND CAPITAL STANDARDS”

Basel II report is the outcome of the Basel Committee on Banking Supervision’s work over
recent years to secure international convergence on revisions to supervisory regulations
governing the capital adequacy of internationally active banks. It has been circulated to
supervisory authorities worldwide with a view to encouraging them to consider adopting this
revised framework. The main objective to amend 1988 Accord has been to develop a framework
that would further strengthen the soundness and stability of the international banking system
while maintaining sufficient consistency that the capital adequacy regulation will not be a
significant source of competitive inequality among internationally active banks.

The revised framework is believed to promote the adoption of stronger risk management
practices by the banking industry and is viewed as the major benefit. The approach of revised
framework is based on three pillars – (a) minimum capital requirements; (b) supervisory review;
and (c) market discipline.

It is believed to be important to repeatedly consider its objectives regarding the overall minimum
capital requirements. These are to broadly maintain the aggregate level of such requirements,
while also providing incentives to adopt the more advanced risk-sensitive approaches of the
revised Framework. The framework is more of forward-looking approach to capital adequacy
supervision, one that has the capacity to evolve with time. The framework also ensures that it
keeps pace with market developments and advances in risk management practices.

In developing the revised Framework, the Committee has sought to arrive at significantly more
risk-sensitive capital requirements that are conceptually sound and at the same time pay due
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regard to particular features of the present supervisory and accounting systems in individual
member countries. It believes that this objective has been achieved. The Committee is also
“Itisisthe
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The Committee also seeks to continue to engage the banking industry in a discussion of
SAS UK SAS UK
prevailing risk management practices, including those practices aiming to produce quantified
measures of risk and economic capital. Over the last decade, a number of banking organizations
have invested resources in modeling the credit risk arising from their significant business
operations. Such models are intended to assist banks in quantifying, aggregating and managing
credit risk across geographic and product lines. The Committee recognizes the importance of
continued active dialogue regarding both the performance of such models and their
comparability across banks. Moreover, the Committee believes that a successful implementation
of the revised Framework will provide banks and supervisors with critical experience necessary
to address such challenges. The Committee understands that the IRB approach represents a point
on the continuum between purely regulatory measures of credit risk and an approach that builds
more fully on internal credit risk models.

The revised Framework provides a range of options for determining the capital requirements for
credit risk and operational risk to allow banks and supervisors to select approaches that are most
appropriate for their operations and their financial market infrastructure.

LITERATURE REVIEW

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Various studies have been made on Credit Risk Management as it has become the hottest topic
due to the fact that inadequate risk policies are still the main source of serious problems within
banking industry.

Managing credit risk thus remains an essential and challenging corporate function. The chief
goal of an effective credit risk management policy must be to maximize a bank’s risk-adjusted
rate of return by maintaining credit exposure within acceptable limits. Moreover, banks need to
manage credit risk in the entire portfolio as well as the risk in individual credits of transactions.

One such research paper was “Best Practices in Effective Credit Risk Management” which
was conducted by LEPUS under the sponsorship of SAS UK. This research was carried by
interviewing 8 risk managers at leading global banks.

According to this research effective credit risk management is a critical component of a bank’s
overall risk management strategy, where active Board and Senior Management oversight,
sufficient policies, procedures & limits, adequate risk measurement, monitoring & management
information systems, and comprehensive internal controls are the major components of effective
credit risk management. Most of the banks laid emphasis on robust technology and few on robust
analytics, however, remaining three, i.e., business processes, policies and exposures were given
equal weightage.

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Technology is widely acknowledged to be a key component of effective credit risk management.
The importance of IT in this issue was focused upon, where most of the banks favored it by
saying that it facilitates active portfolio management, credit risk function and data transparency;
simultaneously emphasizing little on the importance that it eliminates manual process and that it
helps manage information efficiently and effectively.

The research also emphasized on the drivers of effective credit risk management. The regulatory
framework of Basel II has been a facilitator in this regard and that the banks are in compliance
with the accord.

The research also covered various methodologies used for credit risk. Calculating counterparty
credit risk enhances credit risk management capabilities, however, possesses a variety of
challenges too. Different measures are used; the current practice consists of expected and
unexpected loss measures and portfolio management measures, which require current and
potential exposure calculations. Majority of banks used current and potential exposure for the
purpose of measuring credit risk along with Credit VaR. KMV’s Portfolio management was
followed by only 50% of interviewed banks. However, least banks were interested in expected
and unexpected losses; and survival analysis.

Credit risk may be managed with the help of technology either vendor’s technology or in-house.
That is, it might be standardized approach or it may use internal ratings system. Most of the
banks said that they used some form of third party vendor/ consulting coupled with their own
home grown solutions for effective risk management.

It was also observed that most of the staff at most of the banks were employed into credit risk
management which shows that banks consider credit risk management very important for their
business and hence, employment of more number of employees towards the department. It was

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found that business line responsibility is widely spread in credit risk team at the senior
management level.

Respondents overwhelmingly rated

credit risk management as
“fundamental and on the critical
path of [our company’s] business
plan” (86.5 percent). Most of the
remainder (11.7 percent)
considered it “Important, but not a
priority.” The industry sees credit
risk management as a far bigger
issue than a simple matter of regulatory compliance. Indeed, SAS has observed that there is some
“creative tension” between the pragmatic, regulatory compliance- driven approach to credit risk
management and the business case approach. Ideally these should go hand in hand, but we
sometimes see the regulatory approach pushes in a different direction than some business
objectives.

Respondents were also asked to rate

certain factors in terms of their
impact on the development of credit
risk management program. In this
case Basel II was at the top of the
list but it had some statistical score
as “Concerns over exposure
concentrations and ability to identify

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and control them” along with a variety of other business issues and internal management
concerns.

The research findings also stated that most of the banks favored the Basel II IRB approach for
calculating capital requirements; the second preference was for Basel II Standardized approach;
and last priority was applying Basel II IRB foundation approach.

The key findings of this research were:

 Both regulatory compliance and business concerns are driving credit risk management
programs.
 Average increase over the previous year is 24 percent, with very few firms planning a
decrease.
 Half of respondents plan to increase the size of their credit risk management team.
 Companies anticipate significant rewards in terms of reduced capital allocation, loss
reduction and increased revenue.
 Firms recognize data and data history as a major obstacle to successful implementation,
but they need to take data quality more seriously.
 Companies need to become more systematic in their approach to enterprise risk
management.
Conclusion of this survey:

The survey has revealed that financial institutions are continuing to invest in credit risk
management. Overwhelmingly, they see credit risk management as critical and anticipate
significant, quantifiable economic rewards, including:

 A 10 percent reduction in economic capital.

 A 14 percent reduction in cost of losses.

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 CREDIT RISK MODELS

An advanced study in the field of credit risk management gives the financial sector a platform to
concern advanced mathematical models to bring in precision in estimating the default risks of the
counterparty. There have been many studies in this field, which will be widely discussed in this
section. These research studies will give an insight to the functioning of the banks and the
criterion they use apart from the external credit rating.

The upcoming sections discuss the various parameters of Credit Risk Management.

SECTION - I

The Link between Default and Recovery Rates: Implications for Credit Risk Models
Credit risk involves nearly every financial contract. Therefore the measurement, pricing and
management of credit risk have received much attention from financial economists, bank
supervisors and regulators, and from financial market practitioners. Following the recent
attempts of the Basel Committee on Banking Supervision (1999, 2001a) to reform the capital
adequacy framework by introducing risk-sensitive capital requirements, noteworthy extra
consideration has been dedicated to the subject of credit risk measurement by the international
regulatory, academic and banking communities.

This paper analyses the impact of various assumptions on which most credit risk measurement
models are presently based: namely, it analyses the association between aggregate default
probabilities and the loss given default on bank loans and corporate bonds, and seek out to
empirically explain this critical relationship. Moreover, it replicates the effects of this
relationship on credit VaR models, as well as on the procyclicality effects of the new capital
requirements proposed in 2001 by the Basel Committee. Before we carry on with observed and
simulated results, however, the following section is dedicated to a brief review of the theoretical
literature on credit risk modeling of the last three decades.

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The Relationship between Default Rates and Recovery Rates in Credit Risk Modelling: a
Review of the Theoretical and Empirical Literature
Credit risk models can be divided into two main categories:

(a) Credit pricing models, and

(b) Portfolio credit value-at-risk (VaR) models.

Credit pricing models can in turn be divided into three main approaches:

(i) “first generation” structural-form models,

(ii) “second generation” structural-form models, and
(iii) Reduced-form models.
These three different approaches, together with their basic assumptions, advantages, drawbacks
and empirical performance, are briefly outlined in the following paragraphs. Credit VaR models
are then examined. Finally, the more recent studies explicitly modeling and empirically
investigating the relationship between the probability of default (PD) and recovery rates (RR) are
briefly analyzed.

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 FIRST GENERATION STRUCTURAL-FORM MODELS:
THE MERTON APPROACH

The first category of credit risk models is the ones based on the original framework developed by
Merton (1974), using the principles of option pricing (Black and Scholes, 1973). In such a
framework, the default process of a company is driven by the value of the company’s assets and
the risk of a firm’s default is unambiguously related to the variability in the firm’s asset value.

The basic instinct behind this model is relatively simple: default occurs when the value of a
firm’s assets (the market value of the firm) is lower than that of its liabilities. The payment to the
debt holders at the maturity of the debt is therefore the smaller of two quantities: the face value
of the debt or the market value of the firm’s assets. Assuming that the company’s debt is
completely symbolized by a zero-coupon bond, if the value of the firm at maturity is greater than
the face value of the bond, then the bondholder gets back the face value of the bond. However, if
the value of the firm is less than the face value of the bond, the equity holders get nothing and
the bondholder gets back the market value of the firm.

The payoff at maturity to the bondholder is therefore correspondent to the face value of the bond
minus a put option on the value of the firm, with a strike price equal to the face value of the bond
and a maturity equal to that of the bond.

Following this basic instinct, Merton derived an overt formula for default risky bonds, which can
be used both to estimate the PD of a firm and to estimate the yield differential between a risky
bond and a default-free bond. Under these models all the relevant credit risk elements, including
default and recovery at default, are a function of the structural features of the firm: asset
volatility (business risk) and leverage (financial risk). The RR, although not treated overtly in
these models, is therefore an endogenous variable, as the creditors’ payoff is a function of the
residual value of the defaulted company’s assets.

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More precisely, under Merton’s theoretical framework, PD and RR are inversely related. If, for
example, the firm’s value increases, then its PD tends to decrease while the expected RR at
default increases (ceteris paribus). On the other side, if the firm’s debt increases, its PD increases
while the expected RR at default decreases. Finally, if the firm’s asset volatility increases, its PD
increases while the expected RR at default decreases.

Second generation structural-form models

Although the line of research that followed the Merton approach has demonstrated to be very
useful while tackling the qualitatively important aspects of pricing credit risks, it has been less
successful in practical pricing applications. In response to such difficulties, an alternative
approach has been developed which still adopts the original framework as far as the default
process is concerned but, at the same time, removes one of the unrealistic assumptions of the
Merton model, namely, that default can occur only at maturity of the debt when the firm’s assets
are no longer sufficient to cover debt obligations. Instead, it is assumed that default may occur at
any time between the issuance and maturity of the debt, when the value of the firm’s assets
reaches a lower threshold level.

These models include Kim, Ramaswamy and Sundaresan (1993), Hull and White (1995),
Nielsen, Saà-Requejo and Santa Clara (1993), Longstaff and Schwartz (1995) and others.

Under these models, the RR in the event of default is exogenous and independent from the firm’s
asset value. It is generally defined as a fixed ratio of the outstanding debt value and is therefore
independent from the PD. This approach simplifies the first class of models by both exogenously
specifying the cash flows to risky debt in the event of bankruptcy and simplifying the bankruptcy
process. This occurs when the value of the firm’s underlying assets hits some exogenously
specified boundary.
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Despite these improvements, second generation structural-form models still experience from
three main drawbacks, which signify the main reasons behind their reasonably poor observed
performance.

First, they still require estimates for the parameters of the firm’s asset value, which is non-
observable.

Second, they cannot incorporate credit-rating changes that take place quite recurrently for
default-risky corporate debts.

Finally, most structural-form models assume that the value of the firm is continuous in time.

Reduced-form models
The attempt to overcome the above mentioned shortcomings of structural-form models gave rise
to reduced-form models. These include Litterman and Iben (1991), Madan and Unal (1995),
Jarrow and Turnbull (1995), Jarrow, Lando and Turnbull (1997), Lando (1998), Duffie and
Singleton (1999), and Duffie (1998). Unlike structural-form models, reduced-form models do not
condition default on the value of the firm, and parameters related to the firm’s value need not be
estimated to implement them.

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 RECENT CONTRIBUTIONS ON THE PD-RR

RELATIONSHIP

During the last two years, new approaches explicitly modeling and empirically investigating the
relationship between PD and RR have been developed. These models include Frye (2000a and
2000b), Jokivuolle and Peura (2000), Jarrow (2001), and Carey and Gordy (2001).

The model proposed by Frye (2000a and 2000b) illustrates from the conditional approach
suggested by Finger (1999) and Gordy (2000b). In these models, defaults are driven by a single
systematic factor – the state of the economy - rather than by a multitude of correlation
parameters. These models are based on the assumption that the same economic conditions that
cause default to mount might cause RRs to fall, i.e. that the distribution of recovery is different in
high-default time periods from low-default ones. In Frye’s model, both PD and RR depend on
the state of the systematic factor.

The correlation between these two variables therefore obtains from their mutual dependence on
the systematic factor. The instinct behind Frye’s theoretical model is relatively simple: if a
borrower defaults on a loan, a bank’s recovery may depend on the value of the loan collateral.
The value of the collateral, like the value of other assets, depends on economic conditions. If the
economy experiences a recession, RRs may decrease just as default rates tend to increase. This
gives rise to a negative correlation between default rates and RRs.

While the model originally developed by Frye (2000a) implied recovery from an equation that
determines collateral, Frye (2000b) modeled recovery directly. This allowed him to empirically
test his model using data on defaults and recoveries from the U.S. corporate bond market. More
precisely, data from Moody’s Default Risk Service database for the 1982-1997 periods have been
used for the empirical analysis. Results show a strong negative correlation between default rates

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and RRs for corporate bonds. This evidence is consistent with the most recent U.S. bond market
data, representing a simultaneous increase in default rates and LGDs for both 1999 and 20008.

A rather different approach is the one proposed by Jokivuolle and Peura (2000). The authors
present a model for bank loans in which collateral value is correlated with the PD. They use the
option pricing framework for modeling risky debt: the borrowing firm’s total asset value
determines the event of default. However, the firm’s asset value does not determine the RR.

Rather, the collateral value is in turn presumed to be the only stochastic element determining
recovery. Because of this assumption, the model can be implemented using an exogenous PD, so
that the firm asset value parameters need not be anticipated. In this respect, the model blends
features of both structural-form and reduced-form models. A counterintuitive result of the
Jokivuolle and Peura theoretical model is that the likely RR increases as PD increases. This
result is gained assuming a positive correlation between firm’s asset value and collateral value
under a structural-form type of framework.

A low PD therefore implies that the firm’s asset value has to strongly decline in the future before
default can occur. Therefore, a positive correlation between asset value and collateral value
implies that the latter is likely to be relatively low, too, in the case of default. For high PDs the
firm asset value does not have to decline equally considerably before default can occur. Hence,
the collateral value in default is on average also higher relative to its original value than in the
case of low PD.

Main Models and related Treatment of LGD Relationship between PD

empirical studies and RR

Page | 25
Credit Risk Models
First generation Merton (1974), Black and PD and RR are a PD and RR are inversely
Cox (1976), Geske (1977), function of the related
structural-form
Vasicek (1984), Crouhy structural
models and Galai (1994), Mason characteristics of the
and Rosenfeld (1984). firm.

Second generation Kim, Ramaswamy e RR is exogenous and RR is generally defined as

Sundaresan (1993), a fixed ratio of the
structural-form independent from the
outstanding debt value and
Nielsen, Saà-Requejo, firm’s asset value
models is therefore independent
Santa Clara (1993), Hull
from PD.
and White (1995),
. Longstaff and Schwartz

(1995).

Reduced-form Litterman and Iben (1991), Reduced-form models Reduced-form models

models. Madan and Unal (1995), assume an exogenous introduce separate
Jarrow and Turnbull RR that is either a assumptions on the
(1995), Jarrow, Lando and constant or a dynamic of PD and RR,
Turnbull (1997), Lando stochastic variable which are modeled
(1998), Duffie and independent from PD. independently from the
Singleton (1999), Duffie structural features of the
(1998) and Duffee (1999) firm.

Page | 26
Latest Frye (2000a and 2000b), Both PD and RR PD and RR are negatively
contributions Jarrow (2001), Carey and are stochastic correlated. In the “macro
Gordy (2001), Hu and variables which approach” this derives from
on the PD-RR
Perraudin (2002), Altman depend on a the common dependence on
relationship and Brady (2002). common one single systematic factor.
systematic risk In the “micro approach” it
factor (the state of is supply and demand of
the economy). defaulted securities.

Credit Value at Risk Models

CreditMetricsÒ Gupton, Finger &Bhatia Stochastic variable RR independent from PD

CreditPortfolioView Wilson (1997a and 997b). Stochastic variable RR independent from PD

CreditRisk+Ò Credit Suisse Financial Constant RR independent from PD

Products (1997).

KMV McQuown (1997), Crosbie Stochastic variable RR independent from PD

CreditManagerÒ (1999).

Page | 27
 BANK LENDING POLICY, CREDIT SCORING AND VALUE-AT-RISK

This section builds on the credit-scoring literature and proposes a method to calculate portfolio
credit risk. Individual default risk estimates are used to create a value-at-risk (VaR) measure of
credit risk. In general, credit-scoring models suer from a sample-selection bias. The starting point
is therefore to estimate an unbiased scoring model using the bivariate probit approach. The paper
uses a large data set with Swedish consumer credit data that contains extensive financial and
personal information on both rejected and approved applicants. We study how marginal changes
in a default-risk-based acceptance rule would shift the size of the bank_s loan portfolio, its VaR
exposure and average credit losses. Finally, we compare the risk in the sample portfolio with that
in an efficiently provided portfolio of equal size. The results show that the size of a small
consumer loan does not associated default risk implying that the bank provides loans in a way
that is not consistent with default-risk minimization. VaR calculations indicate that an efficient
selection (by means of a default-risk based rule) of loan applicants can reduce credit risk by up to
80%.

Consumer credit has come to play gradually important role, both as an instrument in the financial
planning of households and as an asset on the balance sheet of financial institutions. By the end
of 2012, Indian consumer credit made up 31% of total lending to the public when excluding
residential loans and amounted to the equivalent of 15% of GDP, or 29% of total private
consumption.

Consequently, investigating the properties of banks lending policies is of interest because of both
the ‘‘household channel’’ and the ‘‘financial market channel’’. Despite the mounting importance
of consumer credit, it is common to see households being quoted in financial markets.

Page | 28
When rationing is the mechanism that allocates resources in credit markets, some applicants will
be excluded from credit despite being similarly creditworthy as those granted a loan, making the
equilibrium that results inefficiently. Since a lender cannot observe borrowers probabilities of
default, credit-scoring models by enabling a lending institution to rank potential customers
according to their default risk can improve the allocation of resources, from a second best
towards the first best equilibrium.

In practice, most credit scoring models suffer from a sample-selection bias because they are
anticipated from a sample of granted loans and the criteria by which applicants are rejected are
not taken into account. However this bias is evaded by designing a bivariate probit model with
two sequential events as the dependent variables: the lenders decision to grant the loan or not,
and conditional on the loan having been provided––the borrowers ability to pay it off or not.
Thus banks utilize their unbiased credit-scoring model to scrutinize the provision of credit by
banks and found that it takes place in a way that is not consistent with default-risk minimization.

The contribution of this section is to augment the usage of credit-scoring models. We propose
that individual estimates of default risk be used to create a measure of credit-risk exposure
resembling the value-at-risk (VaR) concept.

The section focuses on how such a risk measure can be erected for a portfolio of loans and
presents two problems to which it can be applied. A value-weighted, instead of an unweighted
sum, of all individual default risks is a more suitable measure of the risk in a portfolio of loans
for a financial institution to consider when it needs to balance risk and return.

A natural starting point is to estimate an unbiased credit-scoring model, i.e., the bivariate- probit
model. For this purpose a large data set is used that contains extensive financial and personal
information on the loan applicants, both rejected and approved.

Page | 29
Next, we take VaR as the relevant risk measure and study how marginal changes in a default-
risk-based acceptance rule would shift the size of the banks loan portfolio, its VaR exposure and
average credit losses. Finally, the risk in the sample portfolio is compared with that of an
efficiently provided portfolio of equal size. This shows that an important risk-reducing property
of an unbiased credit-scoring model works through the selection of different applicants.

Lending policies and value-at-risk

This section shows why portfolio credit risk instead of default risk can be auxiliary in optimizing
bank lending policy. Estimating individual default risks is merely of limited help, because the
individual risks linkage with aggregate credit losses is unclear. A better way to measure risk is to
weigh individual default risks by value, as one does, for example, in the calculation of VaR.

Studying VaR not only enables the financial institution to get a measure of the credit risk present
in currently administered loans. It also allows for an evaluation of the impact of different lending
policies on (a specific measure of) risk exposure and creates a better basis for an explicit decision
on the implied loss rate. Hence we derive a VaR-measure using a Monte-Carlo simulation of the
bivariate probit model. After that, we show how it can be applied to a typical problem that a
lending institution is dealt with when supplying loans.

At this point we would like to point out two possible limitations of the subsequent analyses.
First, the usefulness of the VaR-measure for policy formation hinges on the banks objectives. If
these include features such as cross-product subsidization, then clearly our proposed VaR-
analysis will not be a sufficient basis for policy decisions.

Second, the choice of default definition matters for the VaR-measure. Our definition, non-
performing loans submitted to a debt-collecting agency, will overestimate actual losses if the
agency manages to collect any of the debts at all. However, it is in principle straightforward to
correct for this bias by conditioning on information from the debt-collecting agency.

Page | 30
By means of a Monte-Carlo simulation similar to the one described above, we can derive the
probability distribution of bank credit losses associated with the acceptance/ rejection rule for
any value of the threshold parameter. Applying a VaR analysis before selecting a lending policy
thus allows the lending institution to decide explicitly on either its aggregate credit risk exposure
or its loss rate. Alternatively, it could choose to pick a desirable loss rate conditional on the VaR
not exceeding some maximum allowable amount of money. Doing so has several advantages.

First, compared to current practice, the risk involved in lending becomes more transparent.
Instead of registering loans that have already become non-performing, the financial institution
will be able to create provisions for future losses. Thus officers gain from both a private (bank)
and a social perspective. From a private perspective because provisions for loan losses on banks
balance sheets will be forward-looking and only lag unexpected events, i.e., events associated
with outcomes beyond the chosen VaR-percentile in the loan-loss distribution.

This should facilitate a more efficient allocation of resources and a more accurate evaluation of
the bank. At an aggregate level, there would be less risk of bankruptcy of financial institutions
and therefore less risk of financial disturbances to the economy.

Secondly, unless the bank sets interest rates individually, this methodology also enables a bank to
pick a risk-premium on top of the risk free rate of interest that is consistent with average credit
risk over the maturity in question.

In Bivariate Probit model has been applied to investigate the implications of bank lending policy.
From an extensive data set evidence is found that banks provide loans in a way that may not be
consistent with default-risk minimization. Earlier research has suggested that banks prefer bigger
loans because they offer higher expected earnings. Since, controlling for other counterparty
characteristics such as total income or total assets, bigger loans are generally thought to be
riskier, maximizing expected earnings would then imply deviating from risk minimization.
However, with the data on the size of all loans that we have at our disposal, size has been shown

Page | 31
not to affect the default risk associated with a loan. The bank, even if it is risk-averse, is thus not
faced with a trade-off between risk and return.

Thus, the inconsistency in banking behavior cannot, at least not for the case of small revolving
loans analyzed in this study, be ascribed to some relation between loan size and return, that
earlier models had not accounted for. This suggests that the banks behavior is either a symptom
of an inefficient lending policy or the result of some other type of optimizing behavior. Banks
may, for example, be forecasting survival time, or loss rates, or both. Another possibility is that
they are maximizing another objective than the rate of return on their loan portfolio, e.g., the
number of customers, lending volume subject to a minimum return constraint, or total profits
from a range of financial products.

Current banking technology does not yet allow for the pursuit of a composite objective such as
the return on a range of products, however. In addition, the above suggestions are not in
agreement with the practices reported to us by the lending institution that provided our data.
Except for rejecting applicants that are too risky, the lending institution has no explicit credit
policy. For this purpose, employees who decide if loan applications should be granted or
rejected, examine part of the personal information that is available from the credit agency; except
for the total exposure at the institution, they do not dispose of any information whatsoever about
either the (historical or expected) return on a loan or the range of products that an applicant
already obtains at the lending institution. Our findings thus bear the evidence of a lending
institution that has either minimized credit risk nor maximized the rate of return, but practice a
simple decision-rule scheme.

RISK MANAGEMENT
Page | 32
RISK MANAGEMENT PROCESS

It must be noted that at the very outset that risk management does not aim at risk reduction. Risk

Management enables banks to manage their risk levels to manageable proportions while not

severely reducing their income. Thus risk management enables the banks to the required level of

exposures in order to meet its profit targets. This balancing act between the risk levels and profits

needs to be well planned.

Page | 33
Page | 34
OBJECTIVES OF RISK MANAGEMENT

The objectives of risk management are the maximization of shareholders wealth. Risk

management is the practice of defining the risk level the institution desires, identifying the risk

level the institution has and using appropriate instruments to control and adjust the level of risk

that the institution is expected to bear.

Risk Management at PSB covers three main areas: 1) Credit Risk; 2) Liquidity and market Risk;

and 3) Operational Risk. The Board of Directors is ultimately responsible for the management of

the risk at the Bank. It approves the bank's risk appetite, risk policies and procedures and the risk

management infrastructure. The Risk Management Committee is a Board Committee that

convenes monthly to be constantly appraised of bank's risk profile and various risk issues. The

Risk Management Division is independent from the line and reports directly to the Risk

Management Committee. It reviews risk exposures versus approved limits, drafts risk policies,

and assists line management in risk reduction strategies.

Risk Credit risk Assets Operation Risk Credit audit

management management Liabilities Risk management review

committee committee management division

Management (CARD)
committee
(RMC) (CRMD) committee (RMD)

(ALCO)
(ORMC)

Page | 35
*Overall * All policy *All policy *Implement *Functions *Independent

responsibility of related to credit related to ting policies namely, loan review.

managing. risk. market risk. strategies. framing of

*Audit
Policies
Entire risk of the *Top executive *Headed by *Monitoring mechanism.
related to risk
bank. level committee chairman companies
development
headed by various
*Device the risk CRMD of system &
chairman, MD, policies.
management models for
comprises of
policy. measuring &
ED’s beside
manages the
*Risk integration GMs of credit
risk &
dept., treasury,
*Implementation
integrated risk
of best risk RMD etc.
management
management *Responsible full.
practice & setup for

various risk implementation

limits. of ALM &

investment

policy/strategy

approved by

board.

Page | 36
CREDIT RISK

 Credit risk is basically risk resulting from uncertainty in counterparty's ability or

willingness to meet its contractual obligations.

 Credit risk is the probability of losses associated with changes in the credit quality of

borrowers or counterparties.

 These losses could arise due to outright default by counterparties or deterioration in credit

quality.

 If credit can be defined as "nothing but the expectation of a sum of money within some

limited time", then credit risk is “the chance that expectation will not be met."

The management of credit risk at PSB includes a continuing review of credit limits, policies and

procedures; the approval of specific exposure and workout situations; the constant re-evaluation

of the loan portfolio and the sufficiency of provisions thereof Credit decisions are delegated

effectively at various levels so that the business generation and quality portfolio can be

maintained effectively.

The credit policy group is responsible for reviewing credit standards and formulating appropriate

credit policies and procedures. Sensitivity analyses on interest rate shocks as well as to

geographic events are regularly undertaken.

PSB has also received the necessary approval for patenting its RATING MODEL --- PSB

TRAC --- for its entire category of lending. The loans with exposure of under Rs 20 lakh have

been rated segment-wise on portfolio basis as per terms of Basel II accord. This means that the

bank would be able to do credit rating on its own for its lendings.

Page | 37
In terms of rating, PSB already has data for default rates for the last SEVEN years. The default

rates and migration matrix are comparable to that of leading credit international rating agencies

such as standard & poor, moody's, fitch and international benchmarks. The default rates are also

within the limits given in Basel II.

PSB has developed 13 models for rating of different categories of borrowers. These models have

been developed in-house. The rating models have been deployed by bank wide through web-

enabled software. PSB is among few banks that have rated entire loan portfolio.

The loans with exposure above Rs 20 lakh have been rated individually while loans with

exposure under Rs 20 lakh are rated segment-wise on portfolio basis in terms of Basel II accord.

The bank has also developed the loss given default and exposure at default methodology and the

systems for extraction of data are being implemented through the data warehouse project

implemented by bank.

LIQUIDITY AND MARKET RISK

In general terms the Liquidity Risk can be defined as the potential inability of a bank to generate

sufficient cash to meet its normal operating requirements (cash expenses and repayment of

liabilities) while the Marker Risk - the risk of adverse price movement such as exchange rates,

the value of securities, and interest rates.

Liquidity risk is monitored and controlled primarily by a gap analysis of maturities of assets and

liabilities, as well as analysis of liquid assets. Liquidity is dimensioned in both day-to-day and

stressed situations. The Bank's policy is to maintain adequate liquidity at all times. Market Risk

is dimensioned and controlled in both controlled by a daily analysis of the value-at-risk (VAR) of

trading instruments. In the balance sheet interest rate risk is dimensioned using earnings-at-risk

(EAR), which arrays the repricing behaviours of assets and liabilities. The volatilities utilized for

Page | 38
this regular analysis are those for a rolling one year period, updated quarterly on both liquidity

and market risks.

OPERATIONAL RISK

Operational Risk, as defined by Basel Committee is the risk of direct or indirect loss resulting

from inadequate or failed internal processes, people or systems or from external events. The

definitions exclude strategic or reputational risk, but include legal risk. Operational risks can

broadly be classified into following categories:-

INFORMATION TECHNOLOGY RISK-System failure, internet virus, inaccurate data and

poor quality of communication etc.

HUMAN RESOURCE RISK-Recruitment procedures, incompetent staff, holiday policy etc.

LOSS TO ASSETS RISK- Risk that damages assets and interrupts business. The damage could

be due to fire, flood or earthquake.

RELATIONSHIP RISK- Changes in regulatory requirements, claims, customer satisfaction,

lawsuits etc

BASEL II: NEED FOR STRENGTHING RISK MANAGENENT IN BANKS

India is gaining prominence in the global market with the second highest growth rate n the

world. A robust banking industry will be an essential element to uphold the enhanced levels of

activities, both in the domestic and international market. Even though the Indian banking system

has under gone trmendous changes in the last decade, the existing risk management is in its

nascent stage, and it needs to get augmented.

Page | 39
The Basel Committee which is part of BIS (Bank of International Settlements) came out with

Basel Capital Accord in 1998. Basel II, which is the succeeding version, was released in 1998.

RBI has already exercised its power in asking the banks to implement Basel - II norms by 31st

March, 2009. Quantifying and accounting for various risks is given significant importance in

these norms and therefore when Basel-II gets implemented, the risk management system in

banking industry will automatically get strengthened.

BASEL-II HAS THREE MAIN PILLARS

The three main pillars of Basel-II are:

Capital Adequacy Requirement

Risk-based Supervision

Market Disclosure

The framework gives the details for embracing the more risk sensitive approach by banks. This is

done by establishing i) Principles for assessing adequacy of the bank's capital; ii) Principle for

supervisors to review such assessment to ensure banks have adequate capital to support their

risks; and iii) Fortification of market discipline by increasing transparency in bank's financial

reporting.

MINIMUM CAPITAL REQUIREMENT

While Basel prescribes 8% as the minimum capital required to be maintained by banks to

safeguard against the risk of insolvency RBI palcing conservative policy has prescribes the same

at 9%. It is measured as

(TOTAL CAPITAL) / (CREDIT RISK + MARKET RISK + OPERATIONAL RISK)

Page | 40
2. SUPERVISORY REVIEW PROCESS

It is intended to encourage banks to develop and use better Risk Management techniques in

monitoring and managing these risks. Such supervisory review will enable early intervention by

supervisors if banks capital does not sufficiently buffer the risks inherent in its business

activities. RBI in this regard has already issued detailed guidelines on supervisory review prices

vide its letter dated 26.3.2008 and advised the banks to develop suitable Internal Capital

Adequacy Assessment Priocess (ICAAP) to ensure continuing solvency through mitigating the

risk which are not covered under pillar I.

3. MARKET DISCIPLINE

The third pillar is about increased public disclosure about the risk profile and available capital

resources with the bank. This ensures adequate market discipline is observed and greater

financial prudence in the bank's investment thereby promoting transparency and good Corporate

Governance.

Implications of BASEL-II for Indian Banks

While implementing Basel II, prime focus will be on regulation and risk management. After

March 2007, bankers who learn to manage their risk effectively will rule the banking industry.

The implication of BASEL - II implementation as a system will take five to seven years to make

them evident. However PSB has already implemented the Basle II for the period ended 31.3.08.

Page | 41
CREDIT RISK MANAGEMENT

Page | 42
The KMV model, on the other hand, estimates the default probability of each firm. Thus, the

output of this model can be used as the input for risk based pricing mechanism and for allocation

of economic capital.

The other two models are the most frequently used models in credit risk literature. Credit metrics

and Credit risk+ are intended to measure the portfolio risk, but impose different restrictions,

make different distributional assumptions and use different techniques for calibration.

Z SCORE MODEL

Altman's Z score model is an application of multivariate discriminant analysis in credit risk

modeling. Discriminant analysis is a multivariate statistical technique that analyses a set of

variables in order to differentiate two or more groups by minimizing the within group variance

and maximizing the between groups variance simultaneously.

Altman started with twenty variables (Financial Ratios) and finally five of them

Were found to be significant.

The resulting discriminant function was

Z= .072X1+0.85X2+3.1X3+0.42X4+X5

Where,

X1= Working capital/ Total Assets

X2= Retained earnings/ Total Assets

X3= Earning before Interest and Taxes/ Total Assets

X4= Market value of equity/ Book value of Total Liabilities

X5= Sales/Total Assets

Page | 43
Altman found a lower bound value of 1.2 (Critical Zone) and an upper bound value of 2.8 (Safe
Zone) to be optimal. Any score in between 1.2 and 2.9 was treated as being in the gray zone.

X1 Component of Z-score (X1=Working Capital/Total Assets)

The ratio of Working Capital to Total Assets is the Z-Score component which is considered to be
a reasonable predictor of deepening trouble for a company. A company which experiences
repeated operating losses generally will suffer a reduction in working capital relative to its total
assets.

X2 Component of Z-Score (X2=Retained Earnings/Total Assets)

The ratio of Retained Earnings to Total Assets is a Z-Score component which provides
information on the extent to which a company has been able to reinvest its earnings in itself. An
older company will have had more time to accumulate earnings so this measurement tend to
create a positive bias towards older companies.

X3 Component of Z-Score (X3=Earning before Taxes+ Interest/Total Assets)

The ratio adjusts a company's earnings for varying income tax factors and makes adjustments for
leveraging due to borrowings. These adjustments allow more effective measurements of the
company's utilization of its assets.

X4 Component of Z-Score (X4= Market Value of Equity/ Total Liabilities)

This ratio gives an indication of how much a company's assets can decline in value before debts
may exceed assets. Equity consists of the market value of all outstanding common and preferred
stock. For a private company the book value of equity is used for this ratio. This depends on
assumption that a private company records its assets at market value.

X5 Component of Z-Score (X5= Net Sales/Total Assets)

This ratio measures the ability of the company's assets to generates sales. This ratio is not
included in the Z-Score model for public industrial companies is:

Z=1.2X1+1.4X2+3.3X3+0.6X4+1.0X5.

Page | 44
A healthy public company has a Z>2.99; it is in the grey zone if 1.81< Z< 2.59; is unhealthy if it
has a Z< 1.1. There are also non-manufacturers' Z-Score model and Emerging Market Scoring
(EMS).

MERTON MODEL

This model assumes that a company has a certain amount of zero-coupon debt that will become
due at a future time T. The company defaults if the value of its asset is less than the promised
debt repayment at time T. The equity of the company is a European call option on the assets of
the company with maturity T and a strike price equal to the face value of the debt. The model can
be used to estimate either the risk neutral probability that the company will default or the credit
spread on the debt.

As inputs, Merton's model requires the current value of the company's assets, the volatility of the
company's assets, the outstanding debt, and the debt maturity.

K M V MODEL

KMV Corporation has built a credit risk model that uses information on stock prices and the
capital structure of the firm to estimate its default probability. The starting point of this model is
the proposition that a firm will default only of its asset value falls below a certain level (Default
Point), which is a function of its liability. It estimates the asset value of the firm and its volatility
from the market value of equity and the debt structure in the option theoretic framework. Using
these two values, a metric (Distance from default or DD) is constructed that represents the
number of standard deviations that the firm's assets value is away from the default point. Finally,
a mapping is done between the DD value and the actual default rate, based on the historical
experience. The result probability is called Expected Default Frequency (EDF).

CREDIT METRICS APPROACH

In April 1997, J.P. Morgan released the credit metrices technical document that immediately set a
new benchmark in the literature of portfolio risk management. This provides a method for
estimating the distribution of value of assets in a portfolio subject to changes in the credit quality
of individual borrower. A portfolio consists of different stand along assets, defined by a stream of
future cash flows each asset has over the possible range of future rating class.
Page | 45
Starting from its initial rating, an asset may end in any one of the possible rating categories. Each
rating category has a different credit spread, which will be used to discount the future cash flows.
Moreover, the assets are correlated among themselves depending on the industry they belong to.
It is assumed that the asset returns are normally distributed and change in asset returns cause the
change in rating category in the future. Finally, the simulation technique is used to estimate the
value distribution of the assets.

CREDIT RISK+

Introduced by Credit Suisse Financial Products, Credit Risk+ is a model of default risk. Each
asset has only two possible ends of period states: Default and Non default. In the event of
default, the lender recovers a fixed proportion of the total exposure. The default rate is
considered as a continuous random variable. It does not try to estimate the default correlation
directly. The default correlation is assumed to be determined by a set of risk factors. Conditional
on these risk factors, default of each obligor follows a Bernoulli distribution. To get the
unconditional probability generating function for the number of defaults, it assumes that the risk
factors are independently gamma-distributed random variables. The final step is to obtain the
probability generating function for losses. The losses are entirely determined by the exposure and
recovery rate.

The banks with robust risk management systems will be able to lower the required regulatory
capital when they move from standardized APPROACH TO INTERNAL RATINGS based
approach. They will be able to lower the required regulatory capital when they move from
standardized approach to internal rating based approach. They will be able to price their services
( products) more appropriately and thus increase value to their stakeholders.

The probability of default of a borrower does not, however, provide the complete picture of the
potential credit loss. Banks also seek to measure how much they will lose, should a borrower
default on an obligation. This is contingent upon two elements. First, the magnitude of likely
loss on the exposure; this is termed as Loss Given Default ( LGD ), and is expressed as a
percentage of the exposure. Secondly, the loss is contingent upon the amount to which the bank
was exposed to the borrower at the time of default, commonly expressed as Exposure at Default
( EAD).

Page | 46
LOSS GIVEN DEFAULT (LGD)

LGD is a weighting that represents the proportion of EAD that will be lost if default occurs. It is
derived within a Credit Risk Model by taking account of any collateral or security that applies to
the transaction/facility and the degree of subordination of a facility.

There are broadly three ways of measuring LGD for an instrument:

1. Market LGD: observed from market prices of defaulted bonds or marketable loans soon
after the actual default event.

2. Workout LGD: The set of estimated cash flows resulting from the workout and/or
collections process, properly discounted, and the estimated exposure.

3. Implied Market LGD: LGDs derived from risky (but not defaulted) bond prices using a
theoretical asset pricing model.

EXPOSURE AT DEFAULT (EAD)

If an asset suffers from a lower valuation or a loan default, the exposure at Default figure is how
much will lose as a result of default. The loss is contingent upon the amount to which the bank
was exposed to the borrower at the time of default, commonly expressed as Exposure At Default.

Exposure at Default is a measure of potential exposure (in currency) as calculated by a

Basel Credit Model for the period of one year or until maturity whichever is soonest.

A bank must provide an estimate of the exposure amount for each transaction (commonly
referred to as Exposure at Default (EAD) in bank's internal systems. All these loss estimates
should seek to fully capture the risks of an underlying exposure.

Page | 47
CREDIT SCORING AND CREDIT ANALYSIS

For loans to individuals or small businesses, credit quality is typically assessed through a process
of credit scoring. Prior to extending credit, a bank or other lender will obtain information about
the party requesting a loan. In the case of bank issuing credit card, this might include the party's
annual income, existing debts, whether they own a house or on rent etc. A standard formula is
applied to the information to produce a number, which is called a credit score. Based upon the
credit score, the lending institution decides whether or not to extend credit.

Many forms of credit risk - especially those associated with larger institutional counterparties -
are complicated and unique. The term credit analysis is used to describe any process for
assessing the credit quality of counterparty. While the term can encompass credit scoring, it is
more commonly used to refer to process that entail human judgment. One or more people called
credit analyst, review

Information about the counterparty. This might include all final statements inclusive of Balance
Sheet, Income Statement, recent trends in the industry, the current economic environment etc.
They may also assess the exact nature of an obligation. For example, secured debt generally has
higher credit quality than does subordinated debt of the same issuer. Based upon their analysis,
they assign the counterparty (or the specific obligation) a credit rating, which can be used for
making credit decisions.

Page | 48
 CREDIT DECISION PROCESS

When a proposal is received it has to go through following steps:

 Balance Sheet Analysis – As just figures don’t tell the exact position one needs to know
about the whole industry to decide upon whether compared to last year company has
performed better in the industry or worse. It is done by the Risk Management Division
(RMD) while doing the rating. It is done on PSB Trac (software), which has a fixed
format and the ratios and main terms needed are calculated automatically. This
information is then needed by the Credit Administration Division also while doing the
appraisal and working capital assessment.

 Review of Accounts (if existing) – In order to know the relations of the company with
the bank, past accounts of that company are viewed, to know whether the company met
with all the terms & conditions or not, whether the interest was paid on time or not,
whether there was overdraft in accounts or the funds was not utilised by the company at
all. Whether the bank’s interest income is increasing or not?

 Risk Rating – To know the probability of default.

 MPBF Assessment – We do assessment of MPBF mainly for two things, firstly to

calculate how much loan should be given and also to recheck the projections/estimations
given by the company for the next year, whether it is in line or not. It can be the case that
in order to get more money from bank, the company has made any changes in their excel
sheets. In this we also look into the justifications given by the company for various heads,
why they keeping the said amount either in the form of pile of stock or in the form of
more receivables or payables. It is done according to the 2 nd method of lending suggested
by the Tandon committee, which states that the bank will fund maximum up to 75% of
the amount required, so the amount available with the company is deducted to know the
amount that the bank will give. If company needs Rs 100 and it already has Rs 30, then
instead of Rs 75(75% of 100), bank will provide only Rs 70.

While calculating MPBF, we don’t take export receivables into consideration, as our
government needs foreign currency and moreover there are very rare chances of default
Page | 49
 in it, so the bank gets the interest free of any cost, they don’t have to take any risk in it
and hence it is 100% funded by the bank, no margin is required for it.

 Terms & Conditions – Loan can be provided in various forms like; cash credit, packing
credit, foreign outward bills for collection, bank guarantee, letter of credit, etc. The bank
decides upon the different combinations of these forms depending upon the requirement
of the borrower. In which all forms the loan will be provided, what will be the rate of
interest charged, charge on current assets, etc.

Board’s Note – It is a standard formats which hselps the appraising official to put the
information in a structured forma and also helps the decision making authority to
analysed the information in a structured way. Such standardization not only improves the
quality of informationto be processed or speed of decision taken, but also helps in inter
firm comparison which is one of the main plank of the portfolio management. This
format coveres framing all the workings giving justifications, suggestions to mitigate
risk, SWOT analysis of the company, reason for acceptance or rejection, signature of the
sanctioning authority.

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 STEPS AND METHODOLOGY FOR APPRAISAL

1. APPLICATION FORM: The first step in appraisal involves filling up of detailed

information about the project in a prescribed form by an entrepreneur seeking financial
assistance. The form is sufficiently comprehensive and covers all important aspects of a
project. It is so designed that an analysis of the information there in should enable the
bank to judge the viability of the project. Proper guidance is provided to the promoters
for completing the application forms.

2. SCRUTINY OF STANDARD APPLICATION FORM:

The next step is in depth study of information submitted by entrepreneur to see that:

 Adequate data has been furnished against every item.

 Prima facie information furnished is correct.
 Information furnished under several items could be cross checked.
 Both in scrutiny of the preliminary information and the processing of the application,
personal discussion between the officials of the financial institution and the
representatives of the borrowing concerns are both necessary and desirable. They help to
reduce avoidable correspondence and thus facilitate disposal of the application.
 Clarification/additional information called for wherever necessary.

A project is likely to receive favorable consideration and detailed appraisal is taken if:

 It has priority according to Govt. guidelines

 The promoters inspire confidence.
 The technology to be adopted is well proven.
 The product to be manufactured have market potential.
 The project cost is not unreasonably high.
 The promoter’s contribution is not unreasonably low.
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 Profitability estimates are conservative and indicate repayment of proposed institutional
loans.
3. SITE VISIT: Third step is site visit by appraisal team consisting of technical and
financial officers. Sufficient notice of site visit should be given to promoters. Visit team
should pay particular attention to assessing suitability of site by ascertaining its distance
from Railway station, National /state highway, sources of raw materials and market for
end-products, timely availability of utilities, particularly power. Environmental protection
arrangements should be carefully scanned to ensure that these would be up to Govt.
specifications .Sources of skilled and unskilled labour and availability of social
infrastructure residential accommodation, school, college, hospital near the site may be
looked into.

4. CREDIT APPRAISAL OF A PROJECT: The appraisal system aims to determine the

credit needs/requirements of the borrower taking into account the financial resources of
the client. The end objective of the appraisal system is to ensure that there is no under -
financing or over - financing. Following are the aspects, which need to be scrutinised and
analysed while appraising:

a) Technical aspects.

c) Financial aspects.

d) Credit Risk Rating.

TECHNICAL ASPECTS

The technical feasibility of project is examined by the engineers in the bank. In a dynamic
market, the product, its variants and the product-mix proposed to be manufactured in terms of its
quality, quantity, value, application and current taste/trend requires thorough investigation. The
feasibility reports furnished by the borrowers are critically examined. In technical appraisal,
following aspects are generally looked into:

i) Location and Site: Based on the assessment of factors of production, markets, Govt.
policies and other factors, Location (which means the broad area) and Site (which
signifies specific plot of land) selected for the Unit with its advantages and
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 disadvantages, if any, should be such that overall cost is minimised. It is to be seen that
site selected has adequate availability of infrastructure facilities viz. Power, Water,
Transport, Communication, state of information technology etc. and is in agreement with
the Govt. policies. The adequacy of size of land and building for carrying out its
present/proposed activity with enough scope for accommodating future expansion needs
to be judged.

ii) Raw Material: The cost of essential/major raw materials and consumables required, their
past and future price trends, quality/properties, their availability on a regular basis,
transportation charges, Govt. policies regarding regulation of supplies and prices require
to be examined in detail. Further, cost of indigenous and imported raw material, firm
arrangements for procurement of the same etc. need to be assessed.

iii) Plant & Machinery, Plant Capacity and Manufacturing Process: The selection of
Plant and Machinery proposed to be acquired whether indigenous or imported has to be
in agreement with required plant capacity, principal inputs, investment outlay and
production cost as also with the machinery and equipment already installed in an existing
unit, while for the new unit it is to be examined whether these are of proven technology
as to its performance. The technology used should be latest and cost effective enabling
the unit to compete in the market. Purchase of reconditioned/old machinery is to be dealt
in terms of laid down guidelines. Compatibility of plant and machinery, particularly, in
respect of imported technology with quality of raw material is to be kept in view. Also
plant and machinery and other equipments needed for various utility services, their
supply position, specification, price and performance as also suppliers' credentials, and in
case of collaboration, collaborators' present and future support requires critical analysis.
Plant capacity and the concept of economic size has a major bearing on the present and
future plans of the entrepreneur(s) and should be related to the availability of raw
material, product demand, product price and technology.

The selected process of manufacturing indicating the adequacy, availability and suitability of
technology to be used alongwith plant capacity, manufacturing process needs to studied in detail
with capacities at various stages of production being such that it facilitates optimum utilisation
and ensures future expansion/ debottlenecking, as and when required. It is also to be ensured
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that arrangements are made for inspection at intermediate/final stages of production for ensuring
quality of goods on successful commencement of production and completion, wherever required.

FINANCIAL ASPECTS

The aspects which need to be analysed under this head should include cost of project, means of
financing, cost of production, break-even analysis, financial statements as also profitability/funds
flow projections, financial ratios, sensitivity analysis which are discussed as under:

1) Cost of Project & Means of Financing

i) The major cost components of any project are land and building including transfer,
registration and development charges as also plant and machinery, equipment for
auxiliary services, including transportation, insurance, duty, clearing, loading and
unloading charges etc. It also involves consultancy and know-how expenses which are
payable to foreign collaborators or consultants who are imparting the technical know-
how. Recurring annual royalty payment is not reflected under this head but is accounted
for under the profitability statements. Further, preliminary expenses, such as, cost of
incorporation of the Company, its registration, preparation of feasibility report, market
surveys, pre-operative expenses like salary, travelling, start up expenses, mortgage
expenses incurred before commencement of commercial production also form part of
cost of project. Also included in it are capital issue expenses which can be in the form of
brokerage, commission, advertisement, printing, stationery etc. Finally, provisions for
contingencies to meet any unforeseen expenses, such as, price escalation or any other
expense which have been inadvertently omitted like margin for working capital
requirements required to complete the production cycle, interest during construction
period, etc. are also part of capital cost of project. It is to be ensured while appraising the
project that cost and various estimates given are realistic and there is no under/over
estimation. Further, these cost components should be supported by proper quotations,
specifications and justifications of land, machinery and know-how expenses etc.

ii) Besides Bank’s loan, the project cost is normally financed by bringing capital by the
promoters and shareholders in the form of equity, debentures, unsecured long term loans and
deposits raised from friends and relatives which are not repayable till repayment of Bank's loan.
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Resources are raised for financing project by raising term loans from Institutions/Banks which
are repayable over a period of time, deferred term credits secured from suppliers of machinery
which are repayable in instalments over a period of time. The above is an illustrative list, as the
promoters have now started raising funds through Euro-issues, Foreign Currency loans, premium
on capital issues, etc. which are sometimes comparatively cheap means of finance. Subsidies
and development loans provided by the Central/State Government in notified backward districts
to attract entrepreneurs are also means of financing a project. It is to be ascertained that
requirement of finance has been properly tied-up for unhindered implementation of a project.
The financing structure accepted must be in consonance with generally accepted levels alongwith
adequate Promoters' stake. The resourcefulness, willingness and capacity of promoter to
contribute the same has also to be investigated.

In case of project finance, the promoter/borrower may bring in upfront his contribution (other
than funds to be provided through internal generation) and the branches should commence its
disbursement after the stipulated funds are brought in by the promoter/borrower. A condition to
this effect should be stipulated by the sanctioning authority in case of project finance, on case to
case basis depending upon the resourcefulness and capacity of the promoter to contribute the
same. It should be ensured that at any point of time, the promoter’s contribution should not be
less than the proportionate share. In order to sandardise the process, PSB is one among the first
few banks which has placed a structured process of the acceptance crietiria of funding and DE
rtaio as also the level of promoter contribution required to be placed upfront in case of project
lending.

2) PROFITABILITY STATEMENT

The profitability statement which is also known as `Income and Expenditure Statement' is
prepared after considering the net sales figure and details of direct costs/expenses relating to raw
material, wages, power, fuel, consumable stores/spares and other manufacturing expenses to
arrive at a figure of gross profit. Thereafter, all other expenses like salaries, office expenses,
packing, selling/distribution, interest, depreciation and any other overhead expenses and taxes
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are taken into account to arrive at the figure of net profit. The projections of profit/loss are
prepared for a period covering the repayment of term loans. The economic appraisal includes
scrutinizing all the items of cost, and examining the assumptions, if any, to ensure that these are
realistic and achievable. There should not be any optimism or pessimism in working out
profitability projections since even a little change in the product-mix from non-remunerative to
remunerative or vice-versa can distort the picture. While preparing profitability projections, the
past trends of performance in an industry and other environmental factors influencing the cost
and revenue items should also be considered objectively.

Generally speaking, a unit may be considered as financially viable, progressive and efficient if it
is able to earn enough profits not only to service its debts timely but also for future
development/growth.

3) BREAK-EVEN ANALYSIS

Analysis of break-even point of a business enterprise would help in knowing the level of output
and sales at which the business enterprise just breaks even i.e. there is neither profit nor loss. A
business earns profit if it operates at a level higher than the break-even level or break-even point.
If, on the other hand, production is below this level, the business would incur loss. The break-
even point in an algebric equation can be put as under:

Break-even point = Total Fixed Cost

(Volume or Units) (Sales price per unit - Variable Cost per unit)

Break-even point = Total Fixed Cost x Sales .

(Sales in rupees) (Sales - Variable Costs)

The fixed costs include all those costs which tend to remain the same upto a certain level of
production while variable costs are those costs which tend to change in proportion with the
volume of production. As regards unit sales price, it is generally the same for all levels of
output.

The break-even analysis can help in making vital decisions relating to fixation of selling price,
make or buy decision, maximising production of the item giving higher contribution etc. Further,
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the break-even analysis can help in understanding the impact of important cost factors, such as,
power, raw material, labour, etc. and optimising product-mix to improve project profitability.

4) RATIOS ANALYSIS

The financial statements, drawn as usual, mainly contain a number of balances, credit and debt,

from perusal whereof, it is not easy to know their economic or financial significance. To

ascertain the functional relationship between relevant figures certain arithmetic calculations are

needed, which are called ratio analysis and are of immense value for undertaking the progress or

otherwise of a business undertaking.

While analysing the financial aspects of project, it would be advisable to analyse the important

financial ratios over a period of time as it may tell us a lot about a unit's liquidity position,

managements' stake in the business, capacity to service the debts etc. The financial ratios which

are considered important are discussed as under:

i) Debt-Equity Ratio

The ratio is very important since it shows the dependence of the unit on outside long term

finance.

It can be worked out as under:

Debt-Equity Ratio = Debt (Term Liabilities) .

Equity (Share capital, free reserves, premium on shares, development rebate reserves, etc.)

There cannot be a rigid rule to a satisfactory debt-equity ratio, lower the ratio higher is the

degree of protection enjoyed by the creditors. Generally the banks or financial institutions

consider the debt equity ratio of 2:1 as reasonable. It, however, is higher in respect of capital

intensive projects like infrastructure, cement, etc. But it is always desirable that owners have a

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substantial stake in the project. Other features like quality of management should be kept in

view while agreeing to a less favorable ratio.

ii) Debt-Service Coverage Ratio (DSCR)

The ratio explains the relationship between the funds available for servicing the long term

outside liabilities (where servicing means regular payment of interest on long term liabilities &

also payment of due amount of principle on year to year basis) on the one hand & amount of

interest & installment of long term outside liabilities on the other side.

The variables taken for calculation of this ratio are:

Debt-Service Coverage Ratio = Net Profit + Depreciation + Annual interest on long term debt

Annual interest on long term debt + Amt of installment of principal payable during the year.

This ratio of 1.5 to 2 is considered reasonable. A very high ratio may indicate the need for lower

moratorium period/repayment of loan in a shorter schedule. On the other hand, if it is less than

1.5, re-assessment of the cash flows is undertaken or the borrowing firm is asked to arrange

interest free long term funds to improve the DSCR.

This ratio provides a measure of the ability of an enterprise to service its debts i.e. `interest' and

`principal repayment' besides indicating the margin of safety. The ratio may vary from industry

to industry but has to be viewed with circumspection when it is less than 1.5.

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CREDIT RISK RATING

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CREDIT RATING

Credit ratings are another useful measure for assessing the loss that can accrue to the lender. If
the rating is high there is a very good chance of the borrower defaulting will be low.

Moody's states that “Ratings are intended to serve as indicators or forecasts of the potential for
credit loss because of failure to pay, a delay in payment, or partial payment."

RBI GUIDELINES ON CREDIT RATING

Banks should have a comprehensive risk scoring/rating system that serves as a single point
indicator of diverse risk factors of counterparty and for taking credit decisions in a consistent
manner. To facilitate this, a substantial degree of standardization is required in ratings across
borrowers. The risk rating system should be designed to reveal the overall risk of lending,
critical input for setting pricing and non-price terms of loans as also present meaningful
information for review and management of loan portfolio. This risk rating, in short, should
reflect the underlying credit risk of the loan book. The rating exercise should also facilitate the
credit granting authorities some comfort in its knowledge of loan quality at any moment of time.

The risk rating system should be drawn up in a structured manner, incorporating, inter alia,
financial analysis, projections and sensitivity, industrial and management risks. The banks may
use any number of financial ratios and operational parameters and collaterals as also qualitative
aspects of management and industry characteristics that have bearings on the creditworthiness of
borrowers. Banks can also weigh the ratios on the basis of the years to which they represent for
giving importance to near term developments. Within the rating framework, banks can also
prescribe certain level of standards or critical parameters, beyond which no proposals should be
entertained. Banks may also consider separate rating framework for large corporate/small
borrowers, traders, etc. that exhibit varying nature and degree of risk. Forex exposures assumed
by corporates who have no natural hedges have significantly altered the risk profile of banks.
Banks should, therefore, factor the unhedged market risk exposures of borrowers also in the
rating framework. The overall score for risk is to be placed on a numerical scale ranging
between 1-6, 1-8, etc. on the basis of credit quality. For each numerical category, a quantitative
definition of the borrower, the loan’s underlying quality, and an analytic representation of the
underlying financials of the borrower should be presented. Further, as a prudent risk

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management policy, each bank should prescribe the minimum rating below which no exposures
would be undertaken. Any flexibility in the minimum standards and conditions for relaxation
and authority, therefore, should be clearly articulated in the Loan Policy.

The credit risk assessment exercise should be repeated biannually (or even at shorter intervals for
low quality customers) and should be delinked invariably from the regular renewal exercise. The
updating of the credit ratings should be undertaken normally at quarterly intervals or at least at
half-yearly intervals, in order to gauge the quality of the portfolio at periodic intervals.
Variations in the ratings of borrowers over time indicate changes in credit quality and expected
loan losses from the credit portfolio. Thus, if the rating system is to be meaningful, the credit
quality reports should signal changes in expected loan losses. In order to ensure the consistency
and accuracy of internal ratings, the responsibility for setting or confirming such ratings should
vest with the Loan Review function and examined by an independent Loan Review Group. The
banks should undertake comprehensive study on migration (upward – lower to higher and
downward – higher to lower) of borrowers in the ratings to add accuracy in expected loan loss
calculations.

PSB - PSB uses a system of internal ratings for the assessment of the credit quality and risk
profile of its borrowers. An internal rating refers to a summary indicator of the risk inherent in an
individual credit quality in an individual credit. Ratings typically embody an assessment of the
risk of loss due to failure by a given borrower to pay as promised, based on consideration of
relevant counterparty and facility characteristics. A rating system includes the conceptual
methodology, management process, and systems that play a role in the assignment of a rating.

For large banks, whose commercial borrowers may number in the tens of thousands, internal
ratings are essential ingredients in effective credit risk management. Without the distillation of
information that rating represent, any comparison of the risk posed by such a large umber of
borrower would be extremely difficult because of need to consider simultaneously many risk
factors for each of many borrowers. Most large banks use ratings in one or more key areas of
risk management that involve credit, such as guiding the loan origination process, portfolio
monitoring and management reporting, analysis of the adequacy of loan loss reserves or capital,
profitability and loan pricing analysis, and as input to formal portfolio risk management models.
Banks typically produce ratings only for business and institutional loans and counterparties. for
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consumer loans the bank has separate score card mechanism which is regularly monitored and
analaysed. Based on this score card models majority of the lend or not credit decisions in
consumer financing is linked. However, my project emphasie on the corporate rating system of
the PSB.

In short, risk ratings are the primary summary indicator of risk for banks' individual credit
exposure. They both shape and reflect the nature of credit decision banks make daily.
Understanding how rating systems are conceptualized, designed, operated, and used in risk
management is thus essential to understanding how banks perform their business lending
function and how they choose to control risk.

INPUTS TO THE RATING TOOL AT PSB

Inputs to the Rating tool are as follows:

1. FINANCIALS: The financials of the company are indicative of the health of a company and
the potentials risks in lending to the company for e.g. If a company already has a large amount of
debt on its Balance Sheet, compared to its cash flows generation capacity, a loan to this
company will be risky.

This can be assessed by critically analyzing the past financial performance, its trends and
expected future performance. This helps in predicting potential risks involved.

2. BUSINESS PERFORMANCE & INDUSTRY OUTLOOK: This is a measure of

operational efficiency and core competency of a company vis-s-vis its competitors. The Business
Performance of a company has a direct relationship with the credit risk of a company as the
business performance determines the generation of cash for debt repayment. The credit rating of
a company can not be assessed without considering the outlook of the industry in which it is
operating. Industry performance very often has a very direct bearing on the performance of the
company. Two companies in different industries would have different credit worthiness
depending on the outlook for their industries.

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A company belonging to an industry that score highly on industry rating would be in a better
poition to strengthen its business position and vice versa.

3. MANAGEMENT EVALUATION: evaluation of management is important not only due to

its impact on the company's performance, which determine its capability to repay, but also from
the point of view of integrity. This is because the intentions of the management determine the
willingness of the company to repay its debt. Also the company driven by strong management is
likely to be better than that of a company having a poor management irrespective of the industry
to which it belongs.

4. CONDUCT OF ACCOUNT: This refers to as how the borrowers' existing accounts with
PSB as also other banks are being conducted and whether any problems are being faced. The
manner in which a borrower has been conducting his accounts in the past-as regards his
willingness and ability to meet his obligation, is a good indicator of how the account is likely to
behave in future as well.

These are the broad parameters on which PSBassesses its borrowers’ risk profile. These
parameters are further divided into sub-parameters for a comprehensive and thorough rating
system.

HOW THE RATING IS DONE

•Individual parameters scored on a scale of 0 to 4

•Scores combined according to weightages to arrive at overall score

•Weights for individual parameters decided after several iterations

•Overall score is on a percent scale

•Percent score is converted to rating on a 7-point scale of ‘AA A’ to ‘D’

PEER COMPARISON:

 A Peer is defined as : A person who is of equal standing with another in a group

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 A Peer Group is defined as : Contemporaries of the same status
 You can select the Companies operating in similar Industry or undertaking similar
activity to that of the Customer being rated for inclusion in the Peer Data.
 Further pruning can be done on basis of product, turnover, capacity
(Sugar/refinery/power), etc.
 Minimum 5 companies are required;
 Optimum can be around 15
 Large corporate Model: Bank has classified its some borrower’s a\c (above some specified
limit) under the large corporate model and rating is done. In this model Bank has given major
emphasis to financial position (financial ratio) of company. Bank has categories in some
parameters:
1. Financial Evaluation
2. Business & Industry Evaluation
3. Management Evaluation
4. Conduct Evaluation

 Mid corporate Model Bank has classified its some borrower’s a\c (above some specified
limit) under the Mid corporate model and rating is done. In this model Bank has given major
emphasis to financial position (financial ratio) of company. Bank has categories in some
parameters:
1. Financial Evaluation
2. Business & Industry Evaluation
3. Management Evaluation
4. Conduct Evaluation

 Small corporate Model: Bank has classified its some borrower’s a\c (above some specified
limit) under the Small corporate model and rating is done. In this model Bank has given major
emphasis to financial position (financial ratio) of company. Bank has categories in some
parameters:
1. Financial Evaluation
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2. Business & Industry Evaluation
3. Management Evaluation
4. Conduct Evaluation

 New Project model: Bank has classified its entire borrower’s a\c, who applied for loans for
new projects or for establishing new units, under the New Project model and rating is done. In
this model Bank has given major emphasis to present position of existing company, ability of
management teams and past experience in the industry. Bank has categories in some parameters:
1. Financial Evaluation
2. Business & Industry Evaluation
3. Management Evaluation
4. Conduct Evaluation
 NBFC Model: Bank has classified its entire borrower’s a\c (who comes under category of
Non Banking Financial Companies) under the NBFC model and rating is done. In this model
Bank has given major emphasis to financial position (financial ratio) & Business Evaluation of
company. Bank has categories in some parameters:
1. Financial Evaluation
2. Business & Industry Evaluation
3. Management Evaluation
4. Conduct Evaluation

USES OF CREDIT RISK RATING

Credit risk rating is one of the important tools to decide in the following matters:

 Whether to lend to a borrower or not: The credit risk rating of a borrower determines the
appetite of the bank in determining exposure level. A bank would be willing to lend to highly
rated borrowers but would not like exposure to borrowers with very poor credit risk rating.

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 Pricing: The risk premium to be charged to a borrower should be determined by its credit
risk rating. Borrowers with poor credit rating should be priced high. Credit rating, however, is
just one amongst several inputs to pricing.

 Risk Mitigants: The extent of collateral security required and the need to step up margin
requirements are linked to credit risk rating of a borrower. The higher the risk category of a
borrower, the greater should be the value of collateral and/or the margins.

 Product mix: There is need to gradually shift from the present form of credit facility by way
of Cash Credit limit to Term Lending in Working Capital. In case of, high credit risk category,
offering demand loan for shorter durations may be considered keeping in view the risk involved.
Conversely, for those borrowers with low credit risk category banks may sanction pre-
determined limits for disbursals at short notice.
Similarly declining interest rate on Cash Credit limits based on the volume of credit availed can
also be offered to low risk borrowers.

 Level of decision-making: The delegation of loan sanction/approval powers can be linked to

the credit risk rating of a borrower. For low risk borrowers, higher power of approval can be at
the branch level to facilitate faster sanctioning of loans thereby ensuring better customer service.
For higher risk borrowers, approval from higher levels may be considered.

 Frequency of renewal and monitoring: Renewal of facility in case of high rated borrowers
can be considered at longer intervals as compared to low rated borrowers. Further, high-risk
borrowers should be monitored on a more frequent basis than the low risk ones. Credit risk
ratings eventually help a bank to assign a probability of default for borrower according to its risk
category. This probability of default is determined statistically from past data by observing the
behaviour of various rated clients over a number of years. The expected losses from a loan can
be determined using this probability of default. This probability will then help to determine the
terms and conditions for the loans in terms of the amount, interest rate to be charged, maturity
etc.

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Credit risk rating will be just one of the inputs which will be used in making the credit decisions,
besides other factors like collateral provided, period and quality of relationship with the
borrower, portfolio concentration etc.

ASSESSMENT OF CREDIT RISK RATING

Credit risk rating tools involve analysis of a company on various parameters such as financials,
industry characteristics, business performance, management quality etc. Different scales can be
used and the above parameters can be combined with appropriate weightages to arrive at a final
score. The credibility of credit risk rating to a large extent depends on the skills of the person
using the rating tool and his integrity in using the model equitably for all concerns.

CHARACTERISTICS OF A GOOD CREDIT RISK RATING SYSTEM

 Sensitivity of ratings to real changes in credit quality. Changes in the credit risk profile of a
borrower should be reflected in the credit ratings

 Lead time with respect to recognised changes in quality. The credit ratings should incorporate
changes as soon as they occur

 Stability of ratings when no change has occurred. The credit ratings should be robust to
fluctuations in the external environment, which do not affect real credit risk.

Objectivity: The credit risk-rating tool should specify guidelines for rating on basis of the various
parameters to minimise the subjectivity in the ratings.

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 IMPORTANT FACTORS OF RATING PROCESS

The rating tool contains several qualitative parameters that are to be evaluated subjectively. It is,
therefore, necessary to be adequately familiar with the company and the industry. Visiting the
company and interacting with its management generally helps the rater in understanding the
underlying activity behind the financial data of the company being analysed; the business
prospect of the company and its management. Information should be collected about the
company from all possible sources to conduct this exercise completely, accurately and in an
authenticated manner.

The data used to rate companies should be annualised & comparable before it is used for rating
purposes. Similarly the financials of the company should be made comparable with peers in case
of change in accounting policies, merger, demerger, acquisition, sell-off etc.

While evaluating a company against the industry the following points should be kept in mind:

- The company’s value should be compared only with peers.

- Size / capacity / volume are indicative factors in selecting peers.

- The sample of companies chosen for the industry comparison should be identical as far as
possible for rating all companies under one particular industry having similar size / capacity /
nature of activity.

- The number of companies in sample should be reasonable i.e. neither too low nor too high.

- The sample size should be of atleast 5 companies. The sample should be first selected from
the activities in which company is operating. If adequate sample is not available from the
same segment of the industry, then other companies operating in other segments but within
the same industry should be selected.

- There may be cases when equitable peers may not available as certain companies are unique.
In such cases, a common factor, say intensiveness of the technology etc, may be determined
to select its peers.

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- Peer comparison being a very important facets in segregating good, bad, not so good
companies, utmost endeavour should be made in selecting the peers and justification for
selecting peers in such one off situation must be provided in the rating format.
For companies where industry data is not available, data for other ‘comparable’ industries can be
used. For example, blade-manufacturing companies can be compared with combined sample of
companies manufacturing blade and other shaving products etc. Similarly Hindustan Aeronautics
Ltd. may be compared with other heavy engineering companies, which also uses intensive
technologies and have a similar size, say in terms of sales turnover.

Wherever a particular parameter is not applicable, no score should be given. The parameter
should be made ‘NA’ so that the weight assigned to that parameter gets distributed among the
other parameters in that section automatically.

For multi-divisional companies, which are involved in more than one industry, evaluation should
be done separately for each business. Thus the management evaluation, conduct of account and
financial evaluation will be done on a common basis. For the business section, each business
should be evaluated and scored separately, taking into account the different industries involved.
A weighted average of these business scores should be calculated, where the weights are
proportional to the contribution of each business to the company’s total sales. This weighted
average should then be combined with the scores in the other sections to arrive at the overall
rating for the company.

The credit risk rating exercise should be done immediately after receipt of audited financial
results of the company and should be delinked invariably from the regular renewal exercise. This
will help the rater to achieve a dispassionate attitude towards Credit Decision linked to rating and
thus help in preserving the integrity of the system. The updating of the credit ratings should be
undertaken normally at quarterly intervals or at least at half-yearly intervals, operationalising of
Preventive Monitoring System (PMS) will be an aid in this regard.
In case latest data of peers is not available for industry comparison, then last available data, not
more than one year old, may be considered.

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For companies, which have not been banking with PSB earlier, the PMS score will not be
available. For such companies, the score obtained excluding conduct of account should be scaled
up to 100 and the rating assigned accordingly. To elaborate, if the score obtained is 45,
excluding score under conduct of account, it should be scaled to 100 as under:

45 X 100 = 50

90
The Credit Policy and Risk Management Department (CPRMD), Head Office will provide the
industry score to be used for all major industries, progressively. Until such time the industry
score may be assigned as 50%.

IMPACT OF SINGLE MOST CRUCIAL FACTOR ON RATING

The vetting authority on the basis of the crucial factors mentioned below may downgrade the
rating of an account.

“Effects of any major developments which are not yet cleared, major damage to plant/stocks,
court judgement on environmental threats, involvement of promoters/company in
excise/FERA/tax-evasion, recovery suit/winding-up petition filed by Creditors/FIs/Banks, any
civil/criminal proceedings against the promoters/company, change of management etc.”

OR

Any other crucial factor, which has come to the notice of the bank and has a substantial effect on
the operational efficiency/viability of the unit such as:

 Affecting willingness/capability of the promoters to repay the debt as per agreed terms
and conditions
 Substantial impairment in the value of assets (including Block Assets/Loans and
Advances/ Investments, Inventory/Debtors)
 Obsolescence of the product or any major change in the Govt. Policies having the
substantial impact on the performance of the company etc.

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OPERATIONAL RISK

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 OPERATIONAL RISK
It is the risk faced by any organization arising due to malfunctioning of internal system, wrong
entering of transactional details, wrong interpretation and judgmental errors made
bymanpower.Operational risk is difficult to quantify and monitor. However certain critical
operations or systems have to be identified, the failure of which would raise survival issues for
the company. Close and constant monitoring of these systems is an essential part of operational
risk management.

Managing Operational Risk is emerging as an important feature of sound risk management

practice in modern financial markets in the wake of phenomenal increase in volume of
transactions, high degree of structural changes and complex technological support systems.
Some of the guiding principles for banks to manage operational risks are identification,
assessment, monitoring and control of these risks. These principles are deal in detail below:

IDENTIFICATION OF OPERATIONAL RISK

Banks should identify and assess the operational risk inherent in all material products, activities,
processes and systems. Banks should also ensure that before new products, activities, processes
and systems are introduced or undertaken, the operational risk inherent in them is subject to
adequate assessment procedures.

Risk identification is paramount for the subsequent development of a viable operational risk
monitoring and control system. Effective risk identification should consider both internal factors
(such as the bank's structure, the nature of the bank's activities, the quality of bank’s human
resources, organizational changes and employee turnover) and external factors (such as changes
in the industry and technological advances) that could adversely affect the achievement of the
bank's objectives.

ASSESSMENT OF OPERATIONAL RISK

In addition to identifying the risk events, banks should assess their vulnerability to these risk
events. Effective risk assessment allows a bank to better understand its risk profile and most

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effectively target risk management resources. Amongst the possible tools that may be used by
banks for assessing operational risk are:

TOOLS FOR ASSESSING OPERATIONAL RISK

SELF RISK ASSESSMENT: A bank assesses its operations and activities against a menu of
potential operational risk vulnerabilities. This process is internally driven and often incorporates
checklists and / or workshops to identify the strengths and weaknesses of the operational risk
environment.

Scorecards, for example, provide a means of translating qualitative assessments into quantitative
metrics that give a relative ranking of different types of operational risk exposures. Some scores
may relate to risks unique to a specific business line while others may rank risks that cut across
business lines. Scores may address inherent risks, as well as the controls to mitigate them.

RISK MAPPING: In this process, various business units, organizational functions or process
flows are mapped by risk types. This exercise can reveal areas of weaknesses and help prioritize
subsequent management action.

KEY RISK INDICATORS:- Key risk indicators are statistics and / or metrics, often financial,
which can provide insight into a bank's risk position. These indicators should be reviewed on a
periodic basis (such as monthly or quarterly) to alert banks to changes that may be indicative of
risk concerns. Such indicators may include the number of failed trades, staff turnover rates and
the frequency and / or severity of errors and omissions. Risk assessment should also identify and
evaluate the internal and external factors that could adversely affect the bank's performance,
information and compliance by covering all risks faced by the bank and operate at all levels
within the bank. Assessment should take account of both historical and potential risk events.

MEASUREMENT OF OPERATIONAL RISK

A key component of risk management is measuring the size and scope of the bank's risk
exposure. As yet, however, there is no clearly established, single way to measure operational risk
on a bank-wide basis. Bank's may develop risk assessment techniques that are appropriate to the
size and complexities of their portfolio, their resources and data availability. A good assessment
model must cover certain standard features.
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An example is the "matrix" approach in which losses are categorised according to the type of
event and the business line in which the event occured. Banks may quantify their exposure to
operational risk using a variety of approaches. For example, data on a bank's historical loss
experience could provide meaningful information for assessing the bank's exposure to
operational risk and developing a policy to mitigate / control the risk.

An effective way of making good use of this information is to establish a framework for
systematically tracking and recording the frequency, severity and other relevant information on
individual loss events.

In this way, a bank can hope to identify which events have the most impact across the entire bank
and which business practices are most susceptible to operational risk. Once potential loss events
and actual losses are defined, a bank can analyze their modeling purposes. Although quantitative
analysis of operational risk is an important input to bank risk management system, these risks
cannot be reduced to pure statistical analysis. Hence, qualitative assessments, such as scenario
analysis will be an integral part of measuring a bank's operational risks.

ASSET LIABILITY MANAGEMENT

Asset-liability management basically refers to the process by which an institution manages its
balance sheet in order to allow for alternative interest rate and liquidity scenarios. Banks and
other financial institutions provide services which expose them to various kinds of risks like
credit risk, interest rate risk, and liquidity risk. Asset liability management is an approach that
provides institutions with protection that makes such risk acceptable. Asset-Liability
Management models enable institutions to measure and monitor risk, and provide suitable
strategies for their management.

The uncertainty of interest rate movements gave rise to interest rate risk thereby causing banks to
look for processes to manage their risk. In the wake of interest rate risk came liquidity risk and
credit risk as inherent components of risk for banks. The recognition of these risks brought Asset
Liability Management to the centre stage of financial intermediation.

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The post-reform banking scenario is marked by interest rate deregulation, entry of new private
sector banks and gamut of new products and greater use of information technology. To cope with
these pressures banks were required to evolve strategies rather than ad-hoc fire fighting
solutions. These strategies are executed in the form of ALM practices. An efficient ALM
technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of the
assets and liabilities as a whole so as to earn a predetermined, acceptable risk/reward ratio.

ALM FRAMEWORK

ALM ORGANISATION:-

The ALCO consisting of the banks senior management including CEO should be responsible for
adhering to the limits set by the board as well as for deciding the business strategy of the bank in
line with the banks budget and decided risk management objectives. ALCO is a decision making
unit responsible for balance sheet planning from a risk return perspective including strategic
management of interest and liquidity risk.

ALM INFORMATION SYSTEM:

Information is the key to the ALM process and an endeavor should be made for the collection of
information accurately, adequately and expeditiously. A good information system gives the bank
management a complete picture of the bank's balance sheet.

ALM PROCESS:

The basic ALM process involves identification, measurement and management of risk
parameters. The RBI in its guidelines has asked Indian Banks to use traditional techniques like
Gap Analysis for monitoring interest rate and liquidity risk. RBI is expecting Indian banks to
move towards sophisticated techniques like Duration, Simulation, and VaR in the future.

The RBI in has initiated two approaches for better measurement and management of interest rate
risk. There is now a mandatory requirement that assets and liabilities should be classified by
time-to-reporting, to create the “interest rate risk statement" (RBI, 1999). This statement is
required to be reported to the board of directors of the bank, and to the RBI (but not to the
public). In addition, the RBI has created a requirement that banks have to build up an 'investment

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fluctuation reserve' (IFR), using profits from the sale of government securities, in order to better
cope with potential losses in the future.

The measurement and monitoring of interest rate risk in most banks, especially in Public Sector
Banks which constitute 75 per cent of banking system, remains largely focused on the earnings
approach. While some banks show an awareness of modern notions of

Interest rate risk, most banks appear to focus on the traditional ‘earning perspectives'.

The interest rate risk statement is also based on the earnings approach. Banks are required to
submit this statement to the RBI.

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 GAP ANALYSIS

The simplest analytical techniques for calculation of Internal Rate of Return (IRR) exposure
begins with maturity. Gap Analysis that distributes interest rate sensitive assets, liabilities and
off-balance sheet positions into a certain number of pre-defined time-bands according to their
maturity ( fixed rate ) or time remaining for their next repricing (floating rate). Those assets and
liabilities lacking definite repricing intervals ( saving bank, cash credit, overdraft, loans , export
finance, refinance from RBI etc.) or actual maturities ( embedded option in bonds with put/call
options, loans, cash credit, overdraft, time deposit etc.) are assigned time-bands according to the
judgment, empirical studies and past experiences of banks.

In order to evaluate the earning exposure, interest Rate Sensitive Assets (RSAs) in each time
band are netted with the interest Rate Sensitive Liabilities (RSLs) to produce a repricing Gap for
that Time band. The positive Gap indicates that banks have more RSAs than RSLs. A positive or
sensitive gap means that an increase in market interest rates could cause an increase in NII.
Conversly, a negative or liability sensitive gap implies that the banks' NII could decline as a
result of increase in market interest rates. The negative gap indicates that banks have more RSLs
than RSAs. The Gap is used as a measure of interest rate sensitivity. The Positive or Negative
Gap is multiplied by the assumed interest rate changes to drive the Earning at Risk ( EaR ). The
EaR method facilitates to estimate how much the earnings might be impacted by an adverse
movement in interest rates. The changes in interest rate could be estimated on the basis of past
trends, forecasting of interest rates.

The periodic gap analysis indicates the interest rate risk exposure of banks over distinct
maturities and suggest magnitude of portfolio changes necessary to alter the risk profile.
However, the Gap report quantifies only the time difference between repricing dates of assets
and liabilities but fails to measure the impact of basis and embedded option risks. The Gap report
also fails to measure the entire impact of a change in interest rate (Gap report assumes that all
assets and liabilities are matured or repriced simultaneously) within a given time-band and effect
of changes in interest rates on the economic or market value of assets, liabilities and off-balance
sheet position. It also does not take into account any differences in the timing of payments that
might occur as a result of changes in interest rate environment.

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In India, this ' interest rate risk statement ' is computed by banks and submitted to the regulator,
the Reserve Bank of India. The statement is, however, not required to be made public. Public
disclosure consists of what is called ' the liquidity statement ', which shows the maturity
distribution where each component is classified based on the time to maturity. If gap analysis had
to be undertaken by independent analysts, then this would require imputation of the interest rate
risks statement using public disclosures.

It is important to emphasize that the level of interest rate risk exposure is a choice that banks in
India do control. Even though interest rate derivatives are absent, and even though most
corporate credit is floating rate, there are two important instruments which a bank does control.

On the asset side, banks choose the duration of the government bond portfolio. Banks in India
hold substantial amount of government bonds, owing to high reserve requirements, and the
duration of the government bond portfolio is an important factor affecting interest rate risk.

On the liabilities side, banks choose the interest rates offered on the time deposits at various
maturities, and thus influence the duration of liabilities. Through these two channels, banks do
have substantial control over their own interest rate risk exposure.

The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-balance
sheet positions into time buckets according to residual maturity or next re-pricing period,
whichever is earlier. RATE SENSITIVITY here means that the asset or the liability is re-priced
at or near current market interest rates within a certain time horizon (or ‘MATURITY
BUCKETS’). All investments, advances, deposits, borrowings, purchased funds, etc. that mature/
re-price within a specified time frame are interest rate sensitive if the banks expect to receive it
within the time horizon. This includes final principal repayment and interim instalments. Certain
assets and liabilities carry floating rates of interest that vary with a reference rate and hence,
these items get re-priced at pre-determined intervals. Such assets and liabilities are rate sensitive
at the time of re-pricing. While the interest rates on term deposits are generally fixed during their
period, the interest rates on advances are basically floating. The interest rate on advances could
be re-priced any number of occassions, corresponding to the changes in BPLR

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The Gaps are identified into following buckets:

 1 Day
 2- 7 days
 8- 14 Days
 15 to 28 days
 29 days to 3 months
 3 months to 6 months
 6 months to 1 year
 1 year to 3 years
 3 years to 5 years
 Above 5 years
 Non sensitive
GAP ANALYSIS FOR PUNJAB NATIONAL BANK

GAP is simply the difference between rate sensitive assets and rate sensitive liabilities. The
assets and liabilities are bucketed into different maturity buckets according to their average time
of maturity. The bucketing depend on the guidelines provided by RBI and also the behavioural
studies of the bank, which may differ from bank to bank. PNB bucketed the various assets and
liabilities as shown in annexure.

The Gap between RSA and RSL is calculated. A positive value indicates an asset sensitivity of
the bank while a negative value indicates liability sensitivity of the bank. PNB is asset sensitive
in the bucket 1-28 days, 6 months- 1 year, 3-5 years and over 5 years while it is liability sensitive
in other remaining buckets. PNB uses a number of financial instruments in order to adjust its
portfolio. The principle type of assets to alter the interest sensitivity of the entire portfolio
includes overnight inter-bank borrowings, short term treasuries, corporate deposits and
repurchase agreement. Gap Analysis still forms a significant part of PNBs operating framework.

NET INTEREST MARGIN (NIM)

Net interest margin is also known as spread or the margin on deployment of a rupee in the
earning assets. The spread along with burden determines the profit and profitability of the bank.
The spread depends on competitiveness of the banking system, the cost structure of market and
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macro-economic environment. In a deregulated competitive and complex market and under
falling interest rate scenario as well as adoption of international standards on prudential
accounting norms, the NIM is narrowing down. Hence, the banks are now required to change
their strategies to work on volumes to generate interest income.

CALCULATING NET INTEREST MARGIN (NIM)

Net Interest Margin (NIM), expressed in % terms = Net Interest Income/ Total
Assets*100
MONITORING OF OPERATIONAL RISK

An effective monitoring process is essential for adequately managing operational risk. Regular
monitoring activities can offer the advantage of quickly detecting and correcting deficiencies in
the policies, processes and procedures for managing operational risk. Promptly detecting and
addressing these deficiencies can substantially reduce the potential frequency and / or severity of
a loss event.

Reserve Bank has proposed that, at the minimum, all banks in India should adopt this approach
while computing capital for operational risk while implementing Basel II.

PSB as of now refers to the Basic Indicator Approach.

BASIC INDICATOR APPROACH, BANKS HAVE TO HOLD CAPITAL FOR

OPERATIONAL RISK

Banks have to hold capital for operational risk equal to fixed percentage (alpha) of a single
indicator which has currently been proposed to be "gross income”. This approach is available for
all banks irrespective of their level of sophistication. The charge may be expressed as follows:

KBIA = [GI*a]/n,

Where

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KBIA = the capital charge under the Basic Indicator Approach

GI = annual gross income, where positive, over the previous three years

a = 15% set by the Committee, relating the industry-wide level of required capital to the
industry-wide level of the indicator.

n = number of previous three years for which gross income is positive,

Gross Income = Net Profit + Provisions & Contengencies + Operating Expenses- Profit on Sales
of HTM Investments- income from insurance - extraordinary / irregular items of income + loss
on sales of HTM Investments.

Basel II provides the following approaches to managing OPERATIONAL RISK

RATIOS USED FOR CREDIT RATING

1. GROWTH RATIOS

Percentage increase in GROSS SAL {(Sales in current year/ sales three years ago)(1/3)}-1*100

2. PROFITABILITY RATIO

A) Operating Profit Ratio : OPBDIT/Net Sales

OPBDIT: Operating profit before depreciation, interest and tax

B) ROCE (Return on Capital Employed)

PBIT/Average Capital Employed, where

PBIT: Profit before Interest and Tax

C) CASH PROFIT RATIO

PBDT/Net Sales, where

PBDT: Profit before depreciation and tax

3. LIQUIDITY RATIO
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Current Ratio

Current Assets/Current Liabilities

4. SOLVENCY RATIO

A) DEBT EQUITY RATIO

Debt/ Equity

B)Total Outside liability to tangible net worth

TOL/TNW, where

TOL= Total Borrowings+ Preference Capital+Current Liabilitiesand provisions+ Bills

Discounting

TNW= Equity Capital+ Reserves and Surpluses- Revaluation reserve- Accumulated losses- Misc
expenses not Written-off-Intangible assets-accumulated depreciation not provided for

5. CASH FLOW ADEQUACY RATIO

A) Operating cash flow to total debt

Operating cash flow/ Total Debt

B) Net operating cash flow to Total Debt

Operating cash flow-interest-dividend-tax/ Total Debt

6. DEBT COVERAGE RATIO

A) Interest Coverage Ratio

EBITDA/Total Interest

EBITDA= Earning before interest, tax, depreciation and amortisation

B) DSCR (Debt Service Coverage Ratio)

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PBDIA/ Interest+ TL Instalments, where

PBDIA= Profit before depreciation, Interest and amortisation Interest+ TL

Instalment=Gross interest on term debt+interest capitalized+lease rent+instalment due for one

year

C) TOTAL CURRENT ASSETS TO SHORT TERM BANK

BORROWINGS

Total current assets/Short term borrowings

7. EFFICIENCY RATIO

A) CURRENT ASSETS TURNOVER RATIO

Net Sales/ Current Assets

B) OPERATING ASSETS TURNOVER RATIO

Net Sales/ Current Assets

OPERATING ASSETS= total assets-(revaluation reserves+capital work in

progress+investments-intangible assets + share application money+ Misc. expenses not written
off-Accumulated expenses-loans and advance group/associates/other companies)+ depreciation

C) INVENTORY TURNOVER RATIO

Cost of goods sold/Average Inventory

D) COLLECTION PERIOD

Average Debtors/Average daily sales

E) CREDITORS HOLDING RATIO

Average creditors/Average daily cost of sales

8. OPERATING RATIO

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A) SHORT TERM BANK BORROWINGS TO NET SALES

Short term bank borrowings/Net Sales

B) RAW MATERIAL TO COST OF PRODUCTION

Total raw material expenses/Cost of Production

RAW MATERIAL EXPENSES = Consumption of raw material,Stores & Spares & packing
expenses, freight inward, handling expenses, octroi, purchase tax and procurement expenses be
also considered as part of raw material expenses.

C) WAGES TO COST OF PRODUCTION

D) POWER TO COST OF PRODUCTION

Power includes power and fuel expenses

E) ADMN & SELLING EXPENSES TO NET SALES

F) COST OF GOODS SOLD TO NET SALES

9. LEVERAGE RATIO

OPERATING LEVERAGE

Total Contribution/Contribution-Fixed Cost

Total Contribution= Sales - Variable Cost

PROBLEMS OF THE STUDY

Credit Risk is the most fundamental risk faced by a banking company. Credit Risk is the risk of

default by a borrower of funds or decline in the credit standing of a borrower. It is the most

difficult to quantify due to the large amount of subjectivity involved in it. Thus credit risk
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management can assist in decision-making. It cannot be a substitute to the judgmental decisions

of a credit officer.

Traditionally credit risk has been managed by setting up limits to the global exposure, industry

exposure, country exposure and individual client/group exposure. Credit risk management is

extremely important as the pricing of a portfolio or a transaction is dependent on the risk factor

built-in it.

Credit risk management has two basic objectives. One is to manage the asset portfolio in a

manner that ensures that the banks have adequate capital to hedge their risks. The other is to

match the returns to the risks.

Among the different types of risks, credit risk is crown jewel as the profitability and liquidity of

a bank depends largely on the forecasted cash flows.

Credit risk can be categorized under two heads:

1) Those supported by security cover.

2) Those fully/partly unsecured or uncovered by appropriate guarantee cover.

The effective management of credit risk is a crucial component of a comprehensive approach to

risk management and essential to the long-term success of any banking organization. In doing so,

it is imperative to be able to quantify risk so that it becomes more objective to deal with it. This

can be done by modeling the risk..

RISK MODELLING

Risk modeling has two different approaches for quantifying credit risk. The first approach is the

development of statistical models through analysis of historical data. The second type of

modeling approach is simulation. Rapid development has taken place and many credit risk and

performance measurements tools are available. Broadly, these tools have included:
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 Sophisticated, empirical default models used in establishing credit risk rating for both

public and private borrowers.

 Risk-adjusted performance measurement tools used in pricing individual loans and

assessing risk-adjusted profitability.

 Portfolio management models used in measuring systematic portfolio concentration with

the assistance of correlation analysis.

ADVANCED CREDIT RATING MODELS

A brief overview of the four credit risk models that have received global acceptance as

benchmarks for measuring stand-alone as well as portfolio credit risk are given below:

 Altman's Z score Model.

 Merton Model

 KMV Model for measuring default risk

 Credit metrics

 Credit Risk+

The first three models were developed to measure the default risk associated with an individual

borrower. The Z score model separates the bad firms or the firms in distress from the set of good

firms, which are able to service their debt obligations in time. Merton model assesses the credit

risk of a company by characterizing the company's equity as a call option on its assets.

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 OBJECTIVES OF STUDY

The objective of this study is to study the credit risk management in banks; how the banks
take care of credit risk; what measures have been taken by banks so far; etc.

 To analyze the credit risk management system in banks.

 To analyze overall functions and procedures of managing credit risk management in
banks.
 To analyze the improvements to the existing procedures of credit risk management
system in bank.

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 RESEARCH METHODOLOGY

RESEARCH DESIGN

It involves the study of the existing credit risk management in banks. Hence, the methodology
involves:

 gathering information on credit risk

 gathering secondary data if available
 preparation of questionnaire
 scrutiny of questionnaire
 finalization of questionnaire
 getting questionnaire filled up by banks through face-to-face interaction or emails,
depending upon the response
 analyzing the filled questionnaire
 making recommendations
DATA COLLECTION METHODS

The primary research is collected through a questionnaire which is sent through email to some
and also had telephonic interactions with some banks. The various issues covered in the
questionnaire were: tools and techniques of credit risk management; credit risk derivatives;
ranking the importance of credit risk management in various areas; existing system; its
advantages and shortcomings; etc.

The secondary research included the study of the various research papers in the field of credit
risk management. The secondary research primarily dealt with the advanced mathematical
models used in risk management. The primary sources for secondary data collection were the
research papers, journals and newsletters.

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The banks covered were 15 in number which included Citibank, Abn Amro, Bank of America,
ICICI ING Vysya, IDBI, HDFC Bank, IndusInd Bank, SBI, Bank of Baroda, Dena Bank, Bank
of India, Oriental Bank of Commerce, Deutsche Bank, American Express Bank

LIMITATIONS OF THE STUDY

1. The major limitation of this study shall be data availability as the data is proprietary and not
readily shared for dissemination.

2. Out of the various ways in which risks can be managed, none of the method is perfect and may
be very diverse even for the work in a similar situation for the future.

3. Each bank, in conforming to the RBI guidelines, may develop its own methods for measuring
and managing risk. As such there will be the problem of gaining a comprehensive overview
of the banking industry per se.

4. Due to the ongoing process of globalization and increasing competition, no one model or
method will suffice over a long period of time and constant up gradation will be required. As
such the project can be considered as an overview of the various risks prevailing in Punjab
National Bank and in the Banking Industry.

5. The concept of risk management implementation is relatively new and risk management tools
can prove to be costly.

6. Due to ever changing environment, many risks are unexpected and the remedial measures
available are based on general experience from the past.

7. Selection of methods depends on the firms expectations as well as the risk appetite. Also risks
can only be minimized not completely erased.

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 ANALYSIS

The questionnaire is circulated to 15 banks through email, some of them over the telephone.
Although the response was quite cold as the issue is quite a sensitive one which is why banks
were not willing to entertain, some of the information provided by them has helped in the study.
The questionnaire comprised of 17 questions.

Separation of credit risk management unit

It is very essential that banks have a separate unit that controls only credit risk management
because it will then work only on this aspect. All the banks that were interviewed have a separate
cell which solely looks after credit risk management. However, these cells are located at the head
office of the banks.

Establishment of a Written Credit Risk Policy

Banks should establish a written credit risk policy which explains about the objectives and
principals of credit risk management process. The banks that were questioned all have a written
policy framework for credit risk management. It is essential to have a written credit risk policy
established so that it’s objectives and rationale is clear throughout the department.

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Calculation of Credit Risk Measurement Inputs

Most of the banks calculate probability of default and recovery rate whereas default correlation is
a new concept to them. 40% do not calculate and for remaining banks studies are going on its
implications.

Calculation of Quantitative Measures of Credit Risk

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Expected Loss, Unexpected Loss and Value at Risk are considered as important quantitative
measure of credit risk. Almost all banks calculate these measures, whereas only 7% banks do not
calculate that actually constitutes only 1 bank under study.

Use of Credit Risk Model/ Software

Yes banks do use credit risk software. Technology is a facilitator in credit risk management as
already discussed earlier. Advancements in technology have changed the face of banking sector
today. If technology would not have been there the economy would have been the same as it was
on the day of independence. Most of the banks today use software that is build by them and used
within the bank so that no other bank would know about it in this competitive world.

Banks have now-a-days developed various softwares for different departments too, which create
a competitive edge for them.

Loans on which Internal Credit Ratings are Applied

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There are various types of loans advanced by a bank. They are classified as loans to big sized
enterprises; consumer loans; loans to small and medium enterprises; bank loans; agricultural
loans; investment/ project loans. Banks face various kinds of risks over these advances.
However, the one that is rated most risky by almost all banks is personal loans a category under
consumer loans, because this type of loan does not carry any security and is an unsecured loan.
Rest other loans are secured ones. The following diagram shows how different banks rank the
level of risky ness over different loans and which one if of the prime importance to them so that
they can apply internal ratings system for such purpose.

The intensity of usage of internal credit rating system is divided into three. The first importance
is laid on personal loans which are a part of consumer loans. Most of the banks consider it to be
the first priority for application of rating system. The second importance is laid on SME loans
and then on big enterprise loans.

Suitability to Basel II norms

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All the banks are into compliance with the Basel II norms. And their internal credit rating system
is suitable to Basel II.

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Credit Risk Management Tools

It is found that most of the banks use collaterals to secure the risk arising from credit. However,
almost every bank uses credit limits to the policy so that a limit is set for extending loan which
again reduces its credit risk. Netting refers to making a net of what comes in and what goes out.
Again its another tool for credit risk management, however, only few banks are applying it.
Diversification of credit risk also has not gained importance among banks for reducing credit
risk.

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Use of Derivatives for Minimizing Credit Risk

Credit Risk is a hot topic now-a-days but it still it requires awareness and research studies. Most
of the banks did not know the use of credit derivatives for minimizing credit risk only 13% knew
and implemented but not on a big scale.

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 CONCLUSION

It is concluded that the existing financial system is lacking in the adoption and
implementation of the advanced mathematical models available. The costs involved in
the implementation are high which increases the banks resistance. The inefficient flow of
information in the markets. Corruption plays an important role here. 80%of the loan
recovery fails not because of the default in the counterparty but due to the non viability of
the lending. The use of the models is dependent of the cyclical trends in the economy
A credit risk management process or policy is in effect, but is not comprehensive enough
to identify and avoid credit risk. There is no mechanism in place to predict the outcome
of the individual decision. Most of the lending till date is based on the traditional methods
of 5 Cs.

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 RECOMMENDATIONS

 The fundamentals of credit risk management have been outlined herewith to provide for a
guideline towards effective credit risk management.
 A comprehensive Credit Risk Management process has been provided to cover the entire
credit cycle and to manage not only liquidity and interest rate risks associated with Banks
but also Credit risk arising from exposure. The CRM process acts as a guideline to
effective credit management.
 Lending of credit at banks is based on judgment of an individual of the department who is
analyzing the borrower. There should be strict adherence to policy guidelines laid down
in such cases so as to reduce credit risk. A strict supervision committee in this regard
should be made visible.
 Identification of probabilities of default is imperative to any financial institution engaged
into lending business.
 The concept of credit scoring has been recommended to identify credit risk associated
with the individual credits. This helps in effectively classifying a potential client into
“good” or “bad”, depending on the predictive variables employed. The development of a
credit scorecard involves statistical techniques and these have discussed in detail. The
credit scorecard intends to remove biasness and support the individual with vital
information that enable credit decision-making.
 Basel II is the main guiding force here for regulatory compliance with regards to credit
and capital requirements so as to supervise the activities of banks of various countries.
 Indian banking sector is not yet developed as far as that of developed countries, hence a
need for implementing such models is highly essential.
 The models are studied and found internationally which may not be as applicable in the
Indian Markets. The implication is dependent on the efficiency of the markets

BIBLIOGRAPHY
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 BOOKS & JOURNALS
1. Credit Risk Measurement: New Approaches to Value at Risk and Other Paradigm second
edition by Anthony Saunders, Linda Allen
2. Framework for Credit Risk Management by Alaistar Graham, Brian Coyle
3. An Introduction to Credit Risk Modeling by Christian Bluhm, Ludger Overbeck,
Christoph Wagner
4. Basel II Accord papers from Bank of International Settlements
5. Research Papers: “Effective Credit Risk Management”; and “Credit Risk Management in
Financial Services Industry”

WEBSITES

 www.creditrisk.com

 www.creditrisk-in-banks.co.in

 www.credit-risk.co.uk.

 www.credit-risk-banks.com

 www.rbipolicy.com

 www.googlesearchengine.com

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 APPENDIX
QUESTIONNAIRE

1. DO YOU HAVE CREDIT RISK MANAGEMENT SUB-UNIT UNDER RISK

MANAGEMENT DIVISION?
YES NO

2. HAS THERE BEEN ESTABLISHMENT OF WRITTEN CREDIT RISK POLICY?

YES STILL IN PROGRESS NO

3. DO YOU CALCULATE FOLLOWING INPUTS?

a. PROBABILITY OF DEFAULT
YES STUDIES STILL GOING ON NO

b. RECOVERY RATE
YES STUDIES STILL GOING ON NO

c. DEFAULT CORRELATION
YES STUDIES STILL GOING ON NO

4. DO YOU CONSIDER FOLLOWING QUANTITATIVE MEASURES OF CREDIT

RISK?
A. EXPECTED LOSS
YES NO

B. UNEXPECTED LOSS
YES NO

C. CREDIT VALUE AT RISK

YES NO

5. DO YOU MEASURE CREDIT RISK USING PORTFOLIO CREDIT RISK MODEL /

SOFTWARE?
YES NO

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 IF YES,

WHICH ONE?

RISK METRICS

CREDIT RISK+

CREDIT PORTFOLIO VIEW

CREDIT MANAGER

CREDIT MONITOR

PORTFOLIO MANAGER

SOFTWARE DEVELOPED BY BANK ITSELF

ANY OTHER, PLEASE SPECIFY__________________________________

6. DO YOU USE INTERNAL CREDIT RATING SYSTEM/ CREDIT SCORING

MODEL?
YES NO

IF YES, PLEASE SPECIFY

__________________________________________________________________

7. RANK THE IMPORTANCE OF INTERNAL CREDIT RATING SYSTEM

ACCORDING TO INTENSITY OF USAGE
BIG SIZED ENTERPRISES _________

CONSUMER LOANS _________

SMALL AND MEDIUM ENTERPRISES _________

BANK LOANS _________

AGRICULTURAL LOANS _________

INVESTMENT/ PROJECT LOANS _________

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 OTHER, PLEASE SPECIFY _________

_______________________

8. WHAT ADVANTAGES DO FIND IN YOUR INTERNAL RATING SYSTEM?

________________________________________________________________________
____________________________________________________________

9. ANY PROBLEMS FACED WITH THE CURRENT CREDIT RATING SYSTEM?

________________________________________________________________________
____________________________________________________________

10. IS YOUR INTERNAL RATING SYSTEM SUITABLE TO BASEL II?

YES NO

11. WHAT ARE THE CREDIT RISK MANAGEMENT TOOLS USED BY YOUR BANK?
DIVERSIFICATION _____

TAKING COLLATERAL _____

CREDIT LIMITS _____

NETTING _____

LOAN SELLING _____

SYNDICATED LOANS _____

SECURITIZATION _____

CREDIT INSURANCE _____

REINSURANCE _____

ANY OTHER, PLEASE SPECIFY_____________________________________

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12. IS YOUR BANK USING CREDIT RISK DERIVATIVES TO MANAGE CREDIT
RISK?
YES NO

13. HAS THE CREDIT RISK MANAGEMENT TOOLS HELPED IN IMPROVING

CUSTOMER RETENTION?
YES NO

IF YES, TO WHAT EXTENT?

_______________________________________________________________

14. HAVE THESE TOOLS ENABLED THE CUSTOMER LOYALTY TOWARDS THE
BANK?
YES NO

15. HAS THERE BEEN IMPROVEMENT IN THE BANK’S POSITIONING AFTER

IMPLEMENTATION OF CREDIT RISK MANAGEMENT TECHNIQUES?
YES NO

16. WHAT HAS BEEN THE IMPACT ON THE COST STRUCTURE OF THE BANK?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________

17. HAS THE IMPLEMENTATION OF CREDIT RISK MANAGEMENT TECHNIQUES

COMPENSATED THE CHANGE IN COST STRUCTURE OF THE BANK?
YES NO

________________________________________________________________________

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